A Dozen Things I’ve Learned from Michael Dell about Business (Pre-2002 edition)

If you have been reading this blog for a while you have probably figured out by now that my posts are a scheme on my part to write about topics that interest me in a way that is more interesting for readers. This blog post about Dell founder Michael Dell is no different. I try to work within a 4,000 word count on each blog post. For this post both for brevity and due to the nature of what I do for a living, I’m going to limit the discussion mostly to pre-2002 events.

As is usual, the Michael Dell quotes are in bold text:

1. “I believe that you have to understand the economics of a business before you have a strategy, and you have to understand your strategy before you have a structure. If you get these in the wrong order, you will probably fail.” Dell’s statement about economics is a reference to microeconomics and not macroeconomics. The distinction between these two types of economics was explained at the 2016 Berkshire shareholder meeting by Charlie Munger who said: “Microeconomics is what we do, macro is what we have to put up with.” Understanding microeconomics is essential if you want to be successful in business since as Munger went on to say business is essentially microeconomics. In his “Five Minute University” bit on Saturday Night Live, Father Guido Sarducci explained business simply: “You buy something and you sell it for more.” It is really quite simple. The math that determines whether you can “sell it for more” is called “unit economics.” How much can you profit from the sale of each unit of what your business produces?

Dell said in the quote above that once you have an understanding of the economics you need a strategy. What is a strategy? My most complete post on strategy is about Michael Porter, who has said: “Strategy is about making choices, trade-offs; it’s about deliberately choosing to be different. The essence of strategy is choosing what not to do. Operational effectiveness is about things that you really shouldn’t have to make choices on; it’s about what’s good for everybody and about what every business should be doing.” After you have a strategy then you can create a structure says Dell. The original structure at Dell was three people assembling PCs working at a six foot table and two more people answering the phone with Dell performing the rest of the necessary functions at the company. The structure of Dell’s business has evolved many times, but always in relation to the underlying economics and the strategy of the business.

2. “When I was 19, I saw what I thought was a huge opportunity to change the way personal computers were made and sold. In high school I purchased and took apart one of the very first IBM PCs. I made two interesting discoveries: 1) none of the parts were made by IBM 2) the system that retailed for $3,000 actually cost IBM about $600. I immediately saw this as an opportunity. I started upgrading my own systems, using the same components as IBM, and selling them. The idea grew from there.” What a 19 year old Michael Dell saw in the PC business was “unit economics” that were quite favorable. Dell saw the opportunity to take $600 in components and transform that into a product that people would pay $3,000 for. Even better, none of the parts were made by IBM so there was no real barrier to entry and as a result IBM did not have wholesale transfer pricing power over his business. Dell was able to find favorable unit economics because Bill Gates also had a favorable strategy with respect to IBM. The most important business decision that took place in the earliest days of Microsoft was Gates’ decision to license Microsoft Basic to MITs (the manufacturer of very first PC known as the Altair) on a non-exclusive basis. This decision by Gates was enabled by the fact that multiple people and businesses can possess the same software at the same time at essentially no incremental cost (software is non-rival). Gates understood the difference between a license and an outright sale which was an essential enabler for both Microsoft and companies like Dell. Gates explained the history of one of the most important deals in business in this way: “The contract with IBM called for us to do all this work on the design of the machine and all this software. We didn’t get paid that much–the total was something like $186,000–but we knew there were going to be clones of the IBM PC. We structured that original contract to allow them. It was a key point in our negotiations.” Paul Allen elaborated: “We already had seen the clone phenomenon in the MITS Altair days. Other companies made machines that succeeded because they were similar to the Altair. For us it had been easy to modify our software so it worked on those machines too.” Not only was Dell able to surf on the phenomenon created by Gates and Allen, he was also able to create his own moat by making some key decisions as will be explained below.

3. “We started the company by building to the customer’s order. And interestingly enough, we didn’t do it because we saw some massive paradigm in the future. Basically, we just didn’t have any capital to mass-produce.” “While that was a great way to start the business, it turned out there was a lot more we could do with it, in terms of building relationships with suppliers, reducing inventories and receiving direct input from customers.”’ Most important, the direct model has allowed us to leverage our relationships with both suppliers and customers to such an extent that I believe it’s fair to think of our companies as being virtually integrated. That allows us to focus on where we add value and to build a much larger firm much more quickly. I don’t think we could have created a $12 billion business in 13 years if we had tried to be vertically integrated.” Dell started his business at a very auspicious time. Powerful forces were transforming the economy and that created massive opportunity for many business. In his 1999 essay Michael Mauboussin pointed out “source of value creation is shifting from physical capital to intellectual capital— from atoms to bits.” Better information technology systems (i.e., bits) allowed Dell to create a vertically integrated solutions with only a fraction of the capital that would have been needed in the traditional business world. Professor Gerald Davis describes this phenomenon:

“In 1950 it might have made economic sense to assemble cars in giant vertically integrated factories in Detroit and ship them from there to the rest of the world. Today, the parts of a business are like interlocking plastic bricks that can be snapped together temporarily and snapped apart when they are no longer needed. Information and communication technologies (ICTs) make starting an enterprise trivially easy, from creating a legal structure to hiring temporary employees to contracting out for production and distribution. Coordinating activities used to be the corporation’s strong suit. Now the corporation is increasingly out-maneuvered by alternative forms of enterprise that are more flexible and less costly. The barriers to entry are falling across a wide swathe of industries. In his famous 1937 article “The Nature of the Firm,” Nobel Prizewinning economist Ronald Coase explained, “The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price system. The most obvious cost of ‘organising’ production through the price mechanism is that of discovering what the relevant prices are.” But what if discovering the relevant prices becomes trivial? What if the inputs of a firm, including labor, can be priced and ordered as they are needed? What if, in place of long-term employees, firms were able to contract for workers if and when they were needed for specific tasks—the way that customers can use the Uber app to order a ride?”

4. “Inventory velocity is one of a handful of key performance measures we watch very closely. It focuses us on working with our suppliers to keep reducing inventory and increasing speed.” “We tell our suppliers exactly what our daily production requirements are. So it’s not, “Well, every two weeks deliver 5,000 to this warehouse, and we’ll put them on the shelf, and then we’ll take them off the shelf.” It’s, ‘Tomorrow morning we need 8,562, and deliver them to door number seven by 7 a.m.’” “Because we build to our customers’ order, typically, with just five or six days of lead time, suppliers don’t have to worry about sell-through. We only maintain a few days—in some cases a few hours—of raw materials on hand. We communicate inventory levels and replenishment needs regularly—with some vendors, hourly.” Dell did not have much capital when he started so he turned a weakness into a strength. Bill Gurley and Jane Hodges described the Dell strategy in a classic article from 1998:

“From a corporate perspective, the best measure of fitness is return on invested capital (ROIC). This measure matters most because over the long haul, capital flows toward investment opportunities with a high ROIC. Inefficient companies, on the other hand, are eventually starved of the cash they need to survive. To understand just how indispensable technology has become, you have to follow the basic math of return on invested capital. To get ROIC, you divide EBIT, or earnings before interest and taxes, by invested capital. Now let’s divide the numerator and the denominator by annual sales. This restates ROIC as operating margin multiplied by asset turnover. In other words, the two components that define a company’s fitness are the ability to charge a high spread between price and actual cost, and the ability to generate sales from a small base of invested capital…. companies that lack competitive information technology will be in serious trouble. They will resemble a 40-year-old trying to win Wimbledon with a small wooden racquet. Their business models may no longer be economically sustainable. Companies like Dell have reached an interesting new stage in the evolution of business–negative working capital. They collect money from customers before they have to acquire components or spend money. This phenomenon allows these companies to grow without raising capital, even if day-to-day profitability is zero.”

Gurley elaborated on Dell’s advantage in another article: “Dell’s incredible five days of inventory allows it to pass on component price declines faster than anyone else in the industry. But perhaps the unique aspect of Dell’s business advantage is its negative cash conversion cycle. Because it keeps only five days of inventories, manages receivables to 30 days, and pushes payables out to 59 days, the Dell model will generate cash–even if the company were to report no profit whatsoever.” Michael Mauboussin describes the results in his essay Atoms, Bits and Cash in November of 1999.

dellpic

5. “We’re free cash flow people.” Dell shares this attribute with many great operators like Costco’s Jim Sinegal. One of my post popular blog posts was on Jeff Bezos. One focus of that post is on his views on the right financial drivers of his business. Bezos is quite clear about what he seeks:

“Percentage margins are not one of the things we are seeking to optimize. It’s the absolute dollar free cash flow per share that you want to maximize, and if you can do that by lowering margins, we would do that. So if you could take the free cash flow, that’s something that investors can spend. Investors can’t spend percentage margins.” “What matters always is dollar margins: the actual dollar amount. Companies are valued not on their percentage margins, but on how many dollars they actually make, and a multiple of that.” “When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.”

Justin Fox explains:

With free cash flow what counts is when the money actually changes hands. So if you have a business where your customers pay you quickly, you manage your inventory well, and you’re able to take your time in paying your suppliers, your free cash flow can be consistently positive even when your net income is not. Which is exactly the kind of business that Jeff Bezos and his colleagues have constructed at Amazon over the past decade. According to my instructor in such matters, Harvard Business School finance professor Mihir Desai, the key metric of a company’s cash-generating prowess is the cash conversion cycle, which is days of inventory plus days sales outstanding (how long it takes your customers to pay you, basically), minus how many days it takes you to pay your suppliers. Super-efficient retailers such as Walmart and Costco have been able to bring their CCC down to the single digits. That’s impressive. But at Amazon last year, the CCC was negative 30.6 days.

6. “The computer industry when [we] entered it had gross margins of 40 percent plus. On top of that, you had dealers with margins of 20 to 30 percent. So the end user was paying a pretty incredible premium over the cost of goods for the product.” “The basic idea was to eliminate the middleman.” “Every breakthrough business idea begins with solving a common problem. The bigger the problem, the bigger the opportunity.” Jeff Bezos famously said that the profit margins of his competitors are Amazon’s opportunity and Dell was an early believer in that approach to business. The longer I am involved the business the more I appreciate the value of being in a business with high gross margins. Life is just better when gross margins are high since you have headroom for sales and marketing as well as profit. By contrast, businesses with low gross margins tend to be soul crushing slogs where every penny spent is another way to go out business. Of course, high gross margins alone are not enough to make a business attractive. You also need a large market. And a moat. At one point I changed the focus of my career from the communications business to the software business and I must admit that a major motivation for the shift was the high gross margins available in software. There were other reason that attracted me like better scalability, but high gross margins are a wonderful thing to have in a business. As Warren Buffett has said: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

7. “If we can buy something that’s very similar to something we can create ourselves, we believe it might not be valuable for us to create it. On the other hand, if we’re thinking about creating something that nobody else has, that’s worth doing.” “Dell Computer came along and said, “Now wait a second. If I understand this correctly, the companies that do nothing but put chips on motherboards don’t actually earn tremendous profit doing it. If we want to earn higher returns, shouldn’t we be more selective and put our capital into activities where we can add value for our customers, not just into activities that need to get done?” I’m not saying those activities are unimportant. They need to get done very, very well. But they’re not sources of value that Dell is going to create. When the company started, I don’t think we knew how far the direct model could take us. It has provided a consistent underlying strategy for Dell despite a lot of change in our industry. Along the way, we have learned a lot, and the model has evolved.” Dell is talking about a point made by Andy Grove, who said once: “You have to understand what it is that you are better at than anybody else and mercilessly focus your efforts on it.” Professor Michael Porter argues “the essence of strategy is choosing a unique and valuable position rooted in systems of activities that are much more difficult to match.” Grove is saying that a business should find this comparative advantage and focus resources on it with passion. Businesses that try to do everything, often end up doing close to nothing.

8. “The consumer has better information, you have transparency of pricing. You can’t trick the consumer anymore. The businesses that had an advantage because they sold things in a geographic area where people had limited information, and they couldn’t travel to go buy something else. Those folks are in real trouble. The Net kind of destroys that business model.” “At the root of any economic system is the cost of transactions. You have something you want to sell, I want to buy it, and what that transaction ultimately costs is tied to the cost of communicating information. The Internet is the latest evolution of communication technology-tremendously powerful because it enhances the flow of information. So basically it’s like a big vacuum that sucks friction out of the economy.” Simply increasing product advertising is often not a solution to increasing sales due to higher levels of transparency enabled by Internet. When customers are as well informed as they are today the best way to acquire customers cost effectively is almost always with an organic customer acquisition strategy, meaning they are attracted to the service because it is a great service. Businesses that must sell their products with huge advertising budgets are losing their edge in the Internet era. Jeff Bezos of Amazon puts it this way: “In the old world, you devoted 30% of your time to building a great service and 70% of your time to shouting about it. In the new world, that inverts. Your brand is formed primarily, not by what your company says about itself, but what the company does.”

9. “Ideas are commodity. Execution of them is not.” “Coming up with the ideas is not the hard part for us. We got more ideas than we know what to do with. The hard part for us is prioritizing the best ones, picking them, and fielding teams to go after them all. We’ve gotta be careful. Because if we go after too many of them, well then we’ll fail to execute, because we won’t have the people, the resources. It’s sort of one foot in front of the other.” “People look at Dell and they see the customer-facing aspects of the direct-business model, the one-to-one relation-ships. What is not really understood is that behind these relationships lies the entire value chain: invention, development, design, manufacturing, logistics, service, delivery, sales. The value created for our customers is a function of integrating all those things.” “If you want to sustain excellence over a long time, you’d better come up with a system that works well. Anyone can sprint for a little while, but you can’t sprint for forty years.” In my blog post on John Doerr I quoted John Doerr as saying “We believe that ideas are easy, execution is everything.” A good idea or invention is necessary, but it is far from sufficient to achieve success in business. It takes an entrepreneur to take an idea or innovation and turn into genuinely scalable business. That means a “roll up your sleeves” and a “make the trains run on time” effort from a team of people. Bill Gates said once: “Being a visionary is trivial. Being a CEO is hard. All you have to do to be a visionary is to give the old ‘MIPS to the moon’ speech — everything will be everywhere, everything will be converged. Everybody knows that. Which is different from being the CEO of a company and seeing where the profits are.” The great CEOs I have seen over the years like John Stanton and Jim Barksdale are masters of execution.

10. “The inspiration initially was my own curiosity about technology and what it could do for people. But I had a sense of urgency about it in 1984. Like all windows of opportunity, they eventually close.” “You have to focus on the point of impact where you can really make a difference in something in a meaningful way. That’s going to evolve. Where you might have had an impact on something three years ago. If you did that same thing now, you wouldn’t have enough of an impact to matter.” Sometimes an opportunity comes along and it has a time stamp. You either grab that opportunity right then and bet big or it is gone. As an example, Bill Gates famously dropped out of Harvard to move to Albuquerque, joining Paul Allen in writing software for the Micro Instrumentation and Telemetry Systems Altair computer they first saw in a Popular Electronics magazine at a newsstand in Harvard Square. The price of the MITS computer in 1975 was $397. It was primitive and lacked easy-to-use software, but even then they could see the potential for this device since they experienced how valuable having access to a computer could be. Despite being their youth, especially in the context of how business was conducted at that time, Gates and Allen realized that if their business was not formed immediately they would miss the opportunity. Gates recalls: “When we saw [the Altair], panic set in. ‘Oh no! It’s happening without us! People are going to write real software for this chip!’” Dell saw his own opportunity and grabbed it. Charlie Munger’s advice is that a person needs a combination of patience and yet aggressiveness when the opportunity is right.

11. “Assets collect risks around them in one form or another. Inventory is one risk, and accounts receivable is another risk. In our case—with 70% of our sales going to large corporate customers—accounts receivable isn’t hard to manage because companies like Goldman Sachs and Microsoft and Oracle tend to be able to pay their bills. But in the computer industry, inventory can actually be a pretty massive risk because if the cost of materials goes down 50% a year and you have two or three months of inventory versus 11 days, you’ve got a big cost disadvantage. And you’re vulnerable to product transitions, when you can get stuck with obsolete inventory.” “Consider what to do with the investment that could be freed up by shedding inventory and other assets now on the balance sheet.” “One of the big changes that is brought about by information technology is that the cost of those connections and those linkages has gone down dramatically. So if you’ve got an operation that builds a component, the cost to communicate worth that operation in an information sense, if it is done electronically goes to zero. That means you can build a linkage between that components supplier and a manufacturer and make it very, very efficient. That enables you to scale more quickly, gives you more flexibility, you can manage supplier networks in a more dynamic fashion, and get things off your balance sheet that aren’t your specialty, and companies can really hone in on something that they’re really great at.” The many ways in which Dell grew by having great financial strategies and tactics is underappreciated. Dell had a succession of great CFOs over the years and it shows. Combine a great CFO and a great information technology infrastructure and that is rocket fuel for success. CFOs take a lot of criticism from engineers since they often put limits on spending. Which reminds me of a story. A CEO I knew took the company’s leadership team on a retreat to a resort that had a large swimming pool filled with hungry alligators. One night the CEO said to the executives: “A person should be measured by courage. Courage is what made me CEO. This is my challenge to each of you: if anyone has enough courage to dive into the pool, swim through those alligators, and make it to the other side, you will be my successor.” While everyone was laughing at the CEO’s crazy offer, they suddenly heard a loud splash. When they turned to look at the source of the splash they saw the CFO of the company in the pool, swimming for his life. Amazingly he swam so fast that he avoided the alligators and was able to make an exit using a ladder at the other side the pool with only a fraction of a second to spare. The shocked CEO approached the CFO and said, “You are amazing. I’ve never seen such courage in my life. You are clearly the right person to be my successor. Tell me what I can do for you.” The CFO, panting for breath, looked up and said, “Well, first of all, you can tell me who the hell pushed me into the pool!”

12. “Try never to be the smartest person in the room. And if you are, I suggest you invite smarter people… or find a different room.” Dell has always had a range of talented people working with him. One example is Thomas J. Meredith, who was at one time Dell’s chief financial officer. There are many other people who have contributed to the success of Dell over the years, many of which are mentioned in this article: entitled: Inside Dell Computer Corporation: Managing Working Capital http://www.strategy-business.com/article/9571?gko=d8c29  As Charlie Munger has said: “Acknowledging what you don’t know is the dawning of wisdom. I believe in the discipline of mastering the best that other people have figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.”

Notes:

Dell on Going Private: http://www.cnbc.com/2014/09/23/after-going-private-dell-isnt-looking-back.html

HBR Interview: https://hbr.org/1998/03/the-power-of-virtual-integration-an-interview-with-dell-computers-michael-dell

Justin Fox: https://hbr.org/2014/10/at-amazon-its-all-about-cash-flow/

Gurley and Hodges Fortune Article: http://archive.fortune.com/magazines/fortune/fortune_archive/1998/10/12/249302/index.htm

WSJ on the Dell Model: http://www.wsj.com/articles/SB944003985432882680

Technology Review Article on Dell: https://www.technologyreview.com/s/401105/direct-from-dell/

Mauboussin on CAP: http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/cap.pdf

Mauboussin on Measuring the Moat: http://csinvesting.org/wp-content/uploads/2013/07/Measuring_the_Moat_July2013.pdf

Mauboussin on Atoms, Bits and Cash: http://giddy.org/dbs/neweconomy.pdf

Professor Davis: http://vanishingcorporation.com/wp-content/uploads/sites/62/2016/02/Davis-Booksite-Excerpt.pdf

Mauboussin: Atoms, Bits and Cash: http://giddy.org/dbs/neweconomy.pdf

A Dozen Things I’ve Learned from Naval Ravikant about Investing, Business and Startups

“[Naval Ravikant] is an entrepreneur and angel investor, a co-author of Venture Hacks, and a co-maintainer of AngelList. Previously he]was a co-founder at Genoa Corp (acquired by Finisar), Epinions.com (IPO via Shopping.com), and Vast.com (white-label classifieds marketplace).”

1. “The cost of starting a company has collapsed.” “As the cost of running a startup experiment is coming down, more experiments are being run.” “Three years ago, companies could for the first time get all the way through a prototype of a service before they even raised seed money. Two years ago, they could make it through launch before raising money. Now, they can start to get traction with a user base by the time they come looking for seed money.” A capitalist economy is an evolutionary system. Innovation and best practices are discovered by the experimentation of entrepreneurs who try to establish the evolutionary fitness of their business. Products and services created as part of this experimentation which have greater fitness survive and other less fit products and services die. Entrepreneurs are essentially running experiments in this evolutionary system when they create or alter a business.  Entrepreneurs are engaged in “deductive tinkering” as they search for better products and services. Eric Ries describes the process in this way: “Learning how to build a sustainable business is the outcome of experiments [which follow] a three step process. Build, measure, learn.”

Why is experimentation so important in an economy? The answer is that experimentation is the best way to deal with one of nature’s solutions to dealing with risk, uncertainty and ignorance: a complex adaptive system. An economy is a complex system in that it is networked and therefore adaptive in ways that a simple formalism, such as used in physics, will fail to predict. Michael Mauboussin explains:

“A complex adaptive system has three characteristics. The first is that the system consists of a number of heterogeneous agents, and each of those agents makes decisions about how to behave. The most important dimension here is that those decisions will evolve over time. The second characteristic is that the agents interact with one another. That interaction leads to the third—something that scientists call emergence: In a very real way, the whole becomes greater than the sum of the parts. The key issue is that you can’t really understand the whole system by simply looking at its individual parts.”

In the case of complex adaptive systems like an economy or a business, the correct approach is to discover solutions via trial and error rather than try to predict. Nassim Taleb describes why the experimentation approach works well: “it is in complex systems, ones in which we have little visibility of the chains of cause-consequences, that tinkering, bricolage, or similar variations of trial and error have been shown to vastly outperform the teleological—it is nature’s modus operandi. But tinkering needs to be convex; it is imperative…. Critically [what is desired is to] have the option, not the obligation to keep the result, which allows us to retain the upper bound and be unaffected by adverse outcomes.” What Taleb is talking about is “convexity” which is something I have written a lot about recently. As an example of convex financial proposition, all a founder or venture capitalist can lose is 100% of what they invest in a startup and yet what they can potentially gain is potentially many multiples of that investment. People will inevitably say when the topic of complex adaptive systems comes up that nothing has emerged from research in this area that allows you to predict the future, which ignores the point that knowing what you can’t predict is one of the most valuable things you can know. Discovery which happens via experimentation via trial and error is a vastly superior way to deal with unpredictability than trying to predict what can’t be predicted.

It is important to note that Ravikant in the quotes above is talking about a specific type of business experiment. One way to look at the impact of business startups is to group them into two categories:

  1. Some startups are an attempt to create entirely new categories of businesses at global scale (e.g., Uber, Salesforce.com or Airbnb).
  1. Some startups are about incremental or local innovation, such as a new frozen yogurt shop or sushi restaurant.

The number of businesses trying to create value in category 1 through business experiments has substantially increased. Comparing a category 1 startup (e.g., a business that will try to achieve a level of success similar to Uber or Airbnb) to a category 2 startup (e.g., new frozen yogurt store on main street) is apples and oranges. As an aside, I believe anyone doing something like opening up a new restaurant or main street retailer deserves a medal for bravery. The competition they face on a daily basis is brutal. These category 2 entrepreneurs are vitally important parts of the what makes capitalism work..

It is also important to understand how much bigger category 2 is than category 1. The number of startups that obtain venture finance for the first time in a given year is relatively small. There are ~ 700-800 firms per quarter in the US which raise venture capital for the first time.  This data is from PitchBook:

FVC

In addition to firms that actually obtain professional venture capital funding there are also a much larger number of startups that are able to conduct experiments based on the personal capital of founders even before seed. I’m not aware of anyone who has compiled a reliable estimate of how many category 1 startup experiments fail to raise seed capital or bootstrap the business to success, but it is a significant number.  The same problem exists for anyone trying to estimate how many startups raise some “friends and family” money. This activity is just to diffuse and distributed to be accurately estimated. Nevertheless, the lower cost of conducting a startup experiments has increased the number of experiments and the level of innovation is higher as a result.

Comparing category 1 to category 2 shows how much bigger the latter category actually is in terms of absolute numbers:

“Firms are individual businesses, while establishments include multiple outlets for existing firms. The Brookings report specifically discussed entrepreneurship, which is why it used the numbers for firms. “The distinction between a new Chase Bank branch opening in your neighborhood versus a brand new community bank is critical — particularly when studying entrepreneurship”…. The  most recent data from Census, released in September 2014, that showed firm deaths in 2012 (424,864) still outnumbered births (410,001). That’s a difference of 14,863, and the figures showed that the gap had been narrowing each year since deaths first outnumbered births by 90,670 in 2009. But, it turns out, Census had released new numbers for 2013 in September of this year. And in doing so, it revised its figures for past years. The latest statistics now show that in 2012, firm births (411,252) were higher than firm deaths (375,192) by 36,060. And the same held true for 2013, when births outnumbered deaths by 5,666. We can expect that figure to be revised, too, when Census releases new figures in the future. …the latest numbers show that more firms are opening than closing.

Firm births

 

My trip to Omaha for the Berkshire shareholder meeting this year was interesting for many reasons but one fact that struck me was how many business, especially in West Omaha, are franchises.

A paper prepared for the Federal Reserve Bank of Cleveland, in August 2014 said there had been a shift away from brand-new businesses toward new outlets of existing businesses, a trend that many Americans may have seen in their own communities. “The Shifting Source of New Business Establishments and New Jobs,” Aug. 21, 2014: We find that while new firms have been forming at a slower pace over the past 33 years and creating fewer jobs, there has been a simultaneous rise in the number of new establishments opened by existing businesses (which we will call new outlets). … Markets that used to be served by independent entrepreneurs creating businesses are now increasingly being served by the expansion of existing businesses.

There are a lot more business in 2 category in absolute numbers but it is category 1 that generates the most fundamental innovation. Do I wish there was more business entry in category 2 and that they were more successful more often?  Definitely. Lots of jobs are created and taxes paid by businesses in category 2.

The additional point that must be considered is that innovation in category 1 can cause both more business failure and more new business starts in category 2. The outcome of this process varies since any given innovation can increase profit or not. Whether profit is generated by any given innovation is determined by the presence of a moat. Am I saying that some innovation at an aggregate level produces no profit or even less overall profit? Yes. Charlie Munger explains the phenomenon best:

“When technology moves as fast as it does in a civilization like ours, you get a phenomenon which I call competitive destruction. You know, you have the finest buggy whip factory and all of a sudden in comes this little horseless carriage. And before too many years go by, your buggy whip business is dead. You either get into a different business or you’re dead—you’re destroyed. It happens again and again and again. There are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.”

2. “Success rates are definitely coming down but that is because the cost of running a startup experiment is coming down…so more experiments are being run. In the old days, we would have one company spend $10 million to figure out if it has a market. Today, maybe that same company could do it under $1-2 million. The capital, as a whole, may make the same or better returns, but yeah, if the failures don’t cost a half of what they used to, you are actually saving money, it is a more efficient market.More experiments inevitably means more failures on an absolute basis. In addition, as the rate of business experimentation rises there will inevitably be an increase in the number of poseurs trying to create new businesses and that will increase failure rates. A lower overall success rate caused by an increase in the number of experiments is a positive tradeoff overall since society benefits from the increased level of innovation. This net benefit for society is created even though most experiments fail and some experiments are being conducted on the margin by poseurs who have little or no idea what they are doing. Success is found by any given business via negativa. For this reason, some failure is essential to the capitalist process since it is what fuels success. What the collapse of the cost of running business experiments has done is radically increased the pace of the discovery process that creates innovation. Because the creative destruction process is now operating as if it has taken steroids, the rate at which profit is turned into consumer surplus has never been greater, especially in the technology sector.

A real economy is messy and there is lots of failure. Failure is in fact an essential part of the process of creating innovation and a healthy economy. A fantasy economy in which fully informed and perfectly rational agents interact with perfect efficiency is believed to reflect reality only by a few people suffering from extreme forms of psychological denial. A child of ten knows humans are not perfectly informed and rational.  Failure is literally everywhere and is essential to making capitalism work given the economy is a nest of complex adaptive systems.

Despite the fact that experimentation is beneficial, it is interesting to think about whether there can be too much failure. Does the existence of too many startups in a given area like a city lower the overall benefit by diluting the talent available for startups of higher quality? I have argued previously that there is a Goldilocks “just right” level of startups that is unique for each city. That city A has a huge number of startups should not be the test of success but rather: what is the outcome of that activity? As many startups as are created in the Bay Area of California may not be optimal for a city like Seattle or New York. How big is the city? How much supporting infrastructure exists? What alternative employment opportunities exist? Does the city’s culture reward or punish failure? Is the culture in that city most supportive of missionaries or mercenaries? Does the city have a major research university?

At some level, the ability of an economy to grow is a brake on the overall level of success that can be created in a given time frame like a year or decade. To illustrate, Warren Buffett made a comment once that could be applied to unicorns waiting to go public as a group:

“Think about a [bunch of unicorns with a combined private valuation of] $500 billion. To justify paying this price, [they] would have to earn $50 billion every year until perpetuity, assuming a 10% discount rate. And if the [businesses don’t] begin this payout for a year, the figure rises to $55 billion annually, and if you wait three years, $66.5 billion. Think about how many businesses today earn $50 billion, or $40 billion, or $30 billion. It would require a rather extraordinary change in profitability to justify that [valuation].”

Regarding the amount that has been invested in breakthrough innovation, Mattermark calculates: “we found that 75% of the approximately $108 billion that investors deployed into these [software] companies is still locked up in private coffers.”

2003

I am conformable in predicting that I do not know who the outcome will be. Lots of unicorns may go public in the next year or two with an IPO, but perhaps in many cases only with a down round. That company A can’t go public at a valuation greater than $1 billion does not mean that it can’t go public at some price. Or maybe large numbers of unicorns will go public at flat or even higher levels. Of course some unicorns may be bought by large already profitable firms for defensive reasons, which allows financial exits by startups to exceed aggregate GDP growth by some amount. We will see what happens soon enough. That’s part of the uncertainty and fun of this process.

3. “The funding market is so bifurcated because outcomes are so bifurcated.” “Startup outcomes fall on a power law distribution. So startup financings look the same way. You’re un-fundable until you’re oversubscribed.” The financial returns from a tiny number of startups have always driven venture capital returns due the inherent convexity of technological innovation. This distribution of financial returns inevitably takes the form of a power law for the best venture capital firms. As just one example to illustrate, the ten biggest exits from 2014 look like this:

2014

2005 looks like this:

2015

Ravikant explains: “The nature of the markets have in many cases become more consumerized. People have caught on to how network effects work.” Network effects are increasingly driving financial success which phenomenon causes investors to put more investment into a smaller number of startups and firms that are deemed to have momentum. As a result, some firms can easily raise billions of dollars if investors see potential network effects, while other firms can’t raise even small amounts of capital.

I recently had a discussion on Twitter with Dave McClure (who I respect a lot) about the power laws in venture capital and my view is that a firm like 500 Startups that makes over 150-200 investments a year has a fundamentally different portfolio that a venture capital firm in the top decile of historical performance that makes < 10 investments a year. One recent survey survey reported that the average venture capital firm looks at 400 business a year and invests in only 5 businesses on average during that year. That data would means that these venture capitalists are investing in about 1% of the businesses they consider. McClure says that his financial return data does not look like a power law, but my view is that this does not mean other venture capital firms that embrace more convexity and make fewer investments do not have a return distribution that looks like a power law. All the data I have seen over the years indicates that top venture capital firms have a return distribution that reflect a power law. My thesis is that these views can be reconciled by looking at the composition of the two different portfolios. When financial exits reflect a power law and the head of the distribution is only a handful of companies, investing at a very high rate in any given year inevitably means you are in the tail for more investments.

PLVC

My thesis is that the 500 Startups portfolio is fundamentally different than the portfolio of a firm that Peter Thiel talks about below. This is from a blog post by Jerry Neumann linked to in the notes below:

“At a given alpha, the more investments you make, the better, because your mean return multiple increases with the number of investments, as does the likeliest highest multiple. Dave McClure makes this case:

‘Most VC funds are far too concentrated in a small number (<20–40) of companies. The industry would be better served by doubling or tripling the average # of investments in a portfolio, particularly for early-stage investors where startup attrition is even greater. If unicorns happen only 1–2% of the time, it logically follows that portfolio size should include a minimum of 50–100+ companies in order to have a reasonable shot at capturing these elusive and mythical creatures.’

Peter Thiel flatly contradicts this:

‘Given a big power law distribution, you want to be fairly concentrated. If you invest in 100 companies to try and cover your bases through volume, there’s probably sloppy thinking somewhere. There just aren’t that many businesses that you can have the requisite high degree of conviction about.’

McClure believes he can find hundreds of companies with high enough growth to maintain his requisite alpha. Thiel thinks this is not possible. Venture capitalists have always faced this tension: the average growth rate of all small businesses in the US is closer to 7.5% than 30%. The pool of companies that can grow fast enough is limited.”

PLLLL

My view is that both McClure’s and Thiel’s approaches to venture capital can be successful just as Warren Buffett and Ray Dalio can be successful with different investing approaches. The financial out-performance can come from different sources of mis-pricing for each of the two approaches. One interesting point: would venture capital  firms in the lower two quartiles improve performance by investing more like 500 Startups? The old joke is that all VC firms are in the top quartile, or at least that is what they say to their limited partners. Do you know any limited partners who have been pitched by a venture capital firms that says it is in the bottom quartile?

The discussion in this blog post to this point has not addressed more than a few questions: Why are financial outcomes in venture capital and business in general so bifurcated? What explains the presence of power law distributions? This topic is worthy of its own blog post, but in my view the simplest explanation is that there are many forms of feedback in a world that is a nest of adaptive complex systems and that feedback in all its forms creates the power law distributions. I have always loved this statement by Richard Feynman: “Imagine how much harder physics would be if electrons had feelings!” Duncan Watts describes how this manifests itself in this way: “individuals do not make decisions independently, but rather are influenced by behavior of others.” Humans are not like electrons- they have emotions, do things like herd and otherwise copy each other. That behavior can cause success and failure to feed back on itself, which produces outcomes that under the right conditions reflect a power law.

4.“The Internet is very efficiently arbitraged. Anything you can think of has been thought of and tried. The only way you’re going to find something is if you stick to it, at an irrational level and try a whole bunch of things.” The number of business experiments being conducted is increasing so quickly that the more obvious opportunity spaces for entrepreneurs are being exhausted with unprecedented efficiency and speed. There is no place to hide from the relentless pace of competition if the business person’s plan is to do something conventional. This places a premium on genuine product breakthroughs, often resulting from original research and development. In other words, convexity as a source of out performance is more important than ever.

5. “You get paid for being right first, and to be first, you can’t wait for consensus.” An investor can’t beat the market if they are the market. This is the point made so well by investors like Howard Marks. It is mathematically provable that being right will not lead to outperformance if the consensus forecast is also right. Howard Marks puts is this way: “To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.” Ravikant is saying that you also need to do it first. If you are not first, the bet will probably become consensus before you can capitalize on that bet.

6. “The market has to be huge because everyone makes mistakes. You never quite get it right the first time. Companies that don’t do giant pivots are always doing micro pivots. You need a large enough market that you can pivot in and you still have a customer base.” The convexity of a business investment (potentially massive upside and small potential downside) has never been so important. Having a huge addressable market increases the convexity of the potential financial outcome since it increases optionality. Small addressable markets provide entrepreneurs with fewer options and are not as likely to be convex.

7. “[A $1 billion seed fund would] destroy the entire market and put prices up 20% overnight.” “We don’t think we can allocate that kind of capital without distorting the market.” “Even the $400 million [we raised] will be spread out over six to eight years. Maybe the first year, we’ll deploy $20 or 30 million as we figure out the model, and then scale it out.” The market for venture capital is top down constrained by the potential for financial exits. This scalability problem in the venture capital business that Fred Wilson and others have written about means that in a country like the US only about 800 startups per quarter raised venture capital for the first time. If seed stage valuations get too high, the market can become distorted since it can become hard to raise funds in later rounds. Angel and seed considered together is only slightly higher as this chart indicates:

PBDEALS

 

As I noted above the economy is limited in its ability to generate exists at some level. Yes it can rise more over time with the right environment in place but number of financial exits doesn’t just suddenly jump 10x when overall GDP is increasing only at low single digit levels. One thing that may take the possible exit total higher is that some startup firms are purchased even though only consumers benefit from their existence and there is no net increase in GDP. This creates a weird asymmetry where startups can win without ever making a profit in some cases. The idea that sometimes only consumers benefit from innovation escapes many people. Some innovations have a moat and create profit and some innovations do not have a moat and create no profit.

pb1

 

pb2

 

8. “It’s just as hard to build a large company as it is a small company, so you might as well build a big company. It’s roughly the same effort.” This is yet another point related to convexity. The bigger the upside the greater the convexity.

9. “I use Warren Buffett’s criteria for assessing the Team: Intelligence, Integrity and Energy. You want someone who is really smart, very hard working and trustworthy. A lot of people forget the integrity part, because if you don’t have that, then you have a really hard working crook and they will find a way to cheat you.” “Intelligence and energy are easier to measure. Integrity is the most important factor.” An honest colleague or partners with integrity increases the convexity of an investment since trust gives you more options. Decisions can get made faster and with greater confidence. The work is fun. Life is better. People have actually does research to prove that people who life in high trust societies are happier.  A lot of research has also been done on how trust is a key enabler of an economy. The studies show that “high-trust societies achieve higher economic growth due to lower transaction costs. Since trust protects property and contractual rights, it is not necessary to divert resources from production to protection.” These same ideas about the value of trust are fractal and exist at a company and personal level.

10. “Companies only fail for two reasons: The founder gives up or they run out money.” “Don’t be proud. Get the cash wherever you can. Cash is everything.” “Raise twice as much and make it last four times as long. Pretend that you don’t have the money in the bank, run lean. Assuming your unit economics are at least breakeven, keep your headcount low, raise money and stay in it for the long haul. It takes a decade to build a great company. There’s no shortcuts.” The only unforgivable sin in business is to run out of cash. What does cash give a business? Options. What do options create? Convexity! By now you have probably figured out that convexity is everywhere if you know how to look. “There is a whole set of companies that are not financeable by the venture community; service businesses, markets that are heavily played out, if you are fighting a war that has already been won…you better have some really core differentiation and traction. [Other disqualifiers include] not enough technical people on the team…if you are completely out of market… pre-launch companies tend to not do well…teams that have no credibility. The companies that fail to raise funding are the ones who use too many words and too few actions. Your biography is a record of your past actions. Your execution on your current business is a record of your current actions. Talking about what you are going to do in the future is almost pointless. Talking about what you can become is almost pointless. People want evidence. There is a lot of talk out there.” Most startups will not be able to raise venture capital. That is not the end of the world for those businesses. There are many ways to finance a business that do not involve venture capital.

11. “When building a startup, microeconomics is fundamental, macroeconomics is entertainment.” “Getting real traction is hard. Raising millions of dollars is hard. Building a sustainable, long-term company is hard. Your pre-traction company has not  achieved product/market fit and so it has a hard time hiring.” “There isn’t a shortage of developers and designers. There’s a surplus of founders.” Understanding microeconomics is essential if you want to be successful in business. The distinction between these two types of economics was explained at the 2016 Berkshire shareholder meeting by Charlie Munger who said: “Microeconomics is what we do, macro is what we have to put up with.” Munger and Buffett elaborated on that point during this interchange:

BUFFETT: “Charlie and I read a lot and we’re interested in economic matters and political matters for that matter and so we’re familiar with almost all of that macroeconomic factors. That doesn’t mean we know where they’re going to lead. For example, where zero interest rates are going to lead.”

MUNGER: “We pay a lot of attention to microeconomic factors. If you’re talking about macro we don’t know anything more than anybody else.”

BUFFETT: “Yes, he summed it up. In terms of the businesses we buy – and when we buy stocks we look at it as buying businesses, so they’re very similar decisions – we try to know all or as many as we can know of the microeconomic factors. I like looking at the details of a business whether we buy it or not. I just find it interesting to study the species.”

MUNGER: “Well there hardly could be anything more important that the microeconomics, that is business. Business and microeconomics are sort of the same term.”

12. “Desire is a contract you make with yourself to be unhappy until you get what you want.” “Seems like too many people, public and private sector, are making a living slicing the pie rather than baking it.” “Figure out what you’re good at and start helping other people with it; give it away. Pay it forward. Karma sort of works because people are very consistent. On a long enough timescale, you will attract what you project.”  “If you are young, one of the best things you can do is build a brand around yourself.” Yeah, this last set of quotes is a grab bag of ideas but there is a lot to grab in what he says! This post is already at 4,000 words, so I will let his words speak for themselves.

 

Notes:

Anatomy of a Fundable Startup https://vimeo.com/25392719

Business Insider Interview:  http://www.businessinsider.com/interview-naval-ravikant-co-founder-angellist-and-co-maintainer-venture-hacks-2011-8

Nextweb: http://thenextweb.com/entrepreneur/2011/02/22/naval-ravikant-talks-in-depth-on-twitter-bubbles-new-york-and-start-fund-interview-part-2/#gref

Pando: https://pando.com/2015/05/08/naval-ravikant-to-vcs-you-can-lie-to-your-lps-but-dont-lie-to-yourselves/

Profile: http://dartmouthalumnimagazine.com/articles/avenging-angel

SJBJ: http://www.bizjournals.com/sanjose/blog/techflash/2015/06/angellist-chief-ravikant-its-a-bubble-but-not-just.html

CNBC: http://www.cnbc.com/2015/10/13/

CB Insights:   http://www.forbes.com/sites/niallmccarthy/2015/01/21/the-10-biggest-u-s-venture-capital-exits-of-2014-infographic/#660ae6322917

WSO http://www.wallstreetoasis.com/blog/the-current-state-of-startups-from-naval-ravikant

Power Laws in Venture http://reactionwheel.net/2015/06/power-laws-in-venture.html

Embracing Complexity  https://hbr.org/2011/09/embracing-complexity

Firm deaths and births:  http://www.factcheck.org/2015/11/a-gop-talking-point-turned-false/

Mattermark: https://mattermark.com/75-capital-invested-unicorns-still-locked-private-coffers/?utm_campaign=Mattermark%20Daily&utm_source=hs_email&utm_medium=email&utm_content=33087858&_hsenc=p2ANqtz-_oxddUidtX8i2-IRVA-CTZo5zp4YHD4joHvSJxGTvMmW_BIsyQ-oOi0eEEA3MTIfMS4Ur31j6mG9d1UDAHF9tJgcgkNw&_hsmi=33087858

A Dozen Ways Michael Bloomberg Thinks Like Charlie Munger

After graduating from Johns Hopkins University and Harvard Business School, Michael Bloomberg worked at Salomon Brothers. After he left Salomon Brothers, he started the financial news and information service known as Bloomberg. He was the 108th Mayor of New York City. After leaving City Hall, Michael Bloomberg returned to the company he founded.

As is usual for this blog, Bloomberg’s statements are in bold text.

1. “I think if you look at people, whether in business or government, who haven’t had any moral compass, who’ve just changed to say whatever they thought the popular thing was, in the end they’re losers.” Charlie Munger: The culture now is that anything that can be sold for a profit will be. ‘Can you sell it?’ is the moral test, and that’s not an adequate test.” Munger is unrestrained on this point: “I think we have lost our way when people like the [board of] governors and the CEO of the NYSE fail to realize they have a duty to the rest of us to act as exemplars. You do not want your first-grade school teacher to be fornicating on the floor or drinking alcohol in the closet and, similarly, you do not want your stock exchange to be setting the wrong moral example.”

2. “In 1981, at the age of 39, I was fired from the only full-time job I’d ever had—a job I loved. But I never let myself look back, and the very next day I took a big risk and began my own company based on an unproven idea that nearly everyone thought would fail; making financial information available to people, right on their desktops.” Many people are thrust into a situation with significant optionality by losing a job. When you are already in a position where you have little to lose taking a risk with a potentially big upside can be easier to do. Munger has said that he “developed courage when I learned I could deal with hardship. You need to get your feet wet and get some failure under your belt.”

3. “Persistence really does pay off.” Charlie Munger agrees: “Be persistent: Slug it out one day at a time.” On the subject of persistence, venture capitalist Mark Suster has said: “Tenacity is probably the most important attribute in an entrepreneur. It’s the person who never gives up—who never accepts ‘no’ for an answer….what I look for in an entrepreneur when I want to invest? I look for a lot of things, actually: Persistence (above all else), resiliency, leadership, humility, attention-to-detail, street smarts, transparency and both obsession with their companies and a burning desire to win.”

4. “The most powerful word in the English language is ‘Why.’ There is nothing so powerful as an open, inquiring mind. Whatever field you choose for starting a business—be a lifelong student. The world is full of people who have stopped learning and who think they’ve got it all figured out. Their favorite word is ‘No.’ They will give you a million reasons why something can’t be done or shouldn’t be done. Don’t listen to them, don’t be deterred by them, and don’t become one of them. Not if you want to fulfill your potential—and not if you want to change the world for the better.” People who get ahead most in life are invariably lifelong learners. They read, study and are inquisitive. Charlie Munger puts it this way: “In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time — none, zero.”

5. “I’m a very lucky guy.” “You can’t control how lucky you are, you can’t control how smart you are, but you can control how hard you work, so that’s the first thing.” Charlie Munger has similarly said: “Well, some of our success we predicted and some of it was fortuitous. Like most human beings, we took a bow.” Michael Mauboussin points out: “Skill is ‘the ability to use one’s knowledge effectively and readily in execution or performance.’ You can think of skill as a process, or a series of actions to achieve a specific goal. Luck is the events or circumstances that operate for or against an individual.” “Luck, in this sense, is above and beyond skill. Consider luck as a distribution that has an average of zero. By this definition, luck tends to be transitory. Note that many common phrases, like ‘you make your own luck,’ ‘luck is what happens when preparation meets opportunity,’ and ‘the harder I work, the luckier I get,’ do not fit with our definition. In each of these cases, luck is conflated with skill. Think of luck as something in addition to skill.”

6. “Being a plumber is a great job because you have pricing power.” [The plumber father of one of my employees has] got six plumbers working for him, he’s a scratch golfer, he goes around playing golf courses I only dream about. He’s built a business, he’s had a chance to do that. He never went to college.” A business that can raise prices and demand for the product does not drop significantly has pricing power. Some firms have so much pricing power that they can raise prices and demand goes up. If a business must hold a prayer meeting to raise prices it does not have a moat. A business may have factors that may create a moat in the future, but the best test for a moat is in the end mathematical. Munger believes:

“There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices—and yet they haven’t done it. So they have huge untapped pricing power that they’re not using. That is the ultimate no-brainer. … Disney found that it could raise those prices a lot and the attendance stayed right up. So a lot of the great record of Eisner and Wells … came from just raising prices at Disneyland and Disneyworld and through video cassette sales of classic animated movies… At Berkshire Hathaway, Warren and I raised the prices of See’s Candy a little faster than others might have. And, of course, we invested in Coca-Cola—which had some untapped pricing power. And it also had brilliant management. So a Goizueta and Keough could do much more than raise prices. It was perfect.”

7. “I always give the most difficult and complicated assignment I have to the most overworked person in the company. There’s a reason they don’t have time — work is a marketplace, and it’s telling you this person is good.” What a market does is drench people who want something or make or sell something with feedback says Charlie Munger. Without feedback it is not only hard to respond and adapt to changing conditions, but to figure out who has talent and who is willing to work hard.

8. “None of you are going to be Mark Zuckerbergs. It’s just not going to happen.” As Charlie Munger says about investing: “It’s not supposed to be easy.” If it was easy anyone could do it.” The magnitude of financial success of someone like Zuckerberg or Gates happens extremely rarely. This must be so simply due to the top down math involved. There is only so much profit and revenue to be captured in any given economy given the normal workings of competitive capitalism. Financial success follows a power law distribution.

top1001

9. “If you say, ‘Look, my father never existed, my mum had cancer, I’m working five shifts at McDonald’s,’ that’s the person I’m going to hire.” Charlie Munger: “Life will have terrible blows in it, horrible blows, unfair blows. And some people recover and others don’t. And there I think the attitude of Epictetus is the best. He said that every missed chance in life was an opportunity to behave well, every missed chance in life was an opportunity to learn something, and that your duty was not to be submerged in self-pity, but to utilize the terrible blow in constructive fashion. That is a very good idea. You may remember the epitaph which Epictetus left for himself: “Here lies Epictetus, a slave maimed in body, the ultimate in poverty, and the favored of the gods.”

10. “Capitalism works.” Munger has similarly said, after giving the hat tip to Allen Metzger: “I regard it as very unfair, but capitalism without failure is like religion without hell.” Innovation and progress requires failure. Lots of failure. As Warren Buffett said in his 2015 shareholder letter: “Nothing rivals the market system in producing what people want – nor, even more so, in delivering what people don’t yet know they want.” Capitalism isn’t a perfect system, but it is the best one available by far. Markets sometimes fail, but that can be dealt with wise regulation.

11. “I don’t believe that government is good at picking technology, particularly technology that is changing. By the time you get it done and go through democracy, it’s so outdated.” What a politically driven process lacks is the ability to get real feedback in a timely way about the nature of a given decision. Many political systems are created with a set of “checks and balance” which work against efficiency. Munger: “The constant curse of scale is that it leads to big, dumb bureaucracy—which, of course, reaches its highest and worst form in government where the incentives are really awful. That doesn’t mean we don’t need governments—because we do. But it’s a terrible problem to get big bureaucracies to behave.”

12. “Life is too short to spend your time avoiding failure.” Munger puts it this way: “The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time they don’t. It is just that simple.”

Notes:

Mike Bloomberg: https://www.mikebloomberg.com/about/

The Venture Capital Power Law – Analyzing the Largest 100 U.S. VC-Backed Tech Exits https://www.cbinsights.com/blog/venture-capital-power-law-exits/ 

WSJ on Bloomberg: http://topics.wsj.com/person/B/Michael-Bloomberg/4365

 

 

A Dozen Things I’ve Learned from Bill Draper about Investing and Business

“William H. Draper, III  started his career in venture capital with Draper Gaither & Anderson, the first venture capital firm west of the Mississippi, working there with his father from its creation in 1958 until he left to cofound Draper & Johnson Investment Co. in 1962.  Three years later, Draper & Johnson merged with Sutter Hill Ventures to great success. From 1981-1986, Draper served as President and Chairman of the Export-Import Bank of the US, continuing on to become the Administrator and CEO of the United Nations Development Program, serving until 1995. He is also a co-founder of Draper Richards Kaplan Foundation, a venture philanthropy group focused on early-stage, high impact organizations. He is the author of The Startup Game: Inside the Partnership Between Venture Capitalists and Entrepreneurs.”

 

  1. “Venture was far more profitable 40 years ago than it is today.” “When I was there, the returns at Sutter Hill were 42 percent.” “[There was] much less competition.” “In the early days of VC, the returns were so attractive that they got Wall Street’s attention. But then perhaps it was too much attention.” “It’s not as cozy and not as nice and not as profitable as it used to be.” “It’s much better for the entrepreneur now. The entrepreneur has a chance to go to lots and lots of places. If he doesn’t like Draper, he has a chance to go to Valentine or some other firm.” “This has been good for the overall economy, because it has meant more entrepreneurs could get started. If there were many fewer venture capitalists, perhaps a company like Facebook or Skype wouldn’t have been created in the first place, or been able to get funding.” Competition between venture capitalists has made the world a better place for founders and consumers. The nature of capitalism means that value in any business is constantly moving from producer surplus to consumer surplus driven by increasing competition. Venture capital is not an exception to this phenomenon. The bigger the venture capital business gets and the more money is under management, the harder it us to generate significant out-performance over a benchmark financial return. Timing matters and being early in the venture business was great luck for some people like Draper. Michael Moritz of Sequoia once said at a Fortune magazine conference: “a chimpanzee could have been a successful Silicon Valley venture capitalist in 1986.” Both today and in the past, financial success in the venture capital business overall is top down constrained by the number of successful exits as Fred Wilson pointed on is a classic post on the business. Fred wrote: “$100bn in [venture capital exits in a given year] produces roughly $50bn in proceeds for venture firms per year. After fees and carry, that $50bn is around $40bn. Which is only 1.6x on the investor’s capital if $25bn per year is going into venture funds. If you assume the investors capital is tied up for an average of 5 years (venture funds call capital over a five year period and distribute it back over a five year period, on average), then the annual return is around 10%.” If venture capital industry exits are at the level in the chart below the overall financial returns will necessarily be constrained by the level of financial exits in industry.  As I have written before, venture capital industry returns are far from spread evenly like peanut butter between all of the venture capital firms. The better venture capital firms capture the lion’s share of the financial returns in the industry. The venture capital business is certainly not like Lake Wobegon where all firms are above average. If the top down industry constraint is ~$100B a year on average, only so many startups (unicorns or otherwise) can achieve an exit in a given year.

pitch

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  1. “We had many fewer failures in [the early years of venture capital] In our day we had really very few losses.  At Sutter Hill, we had a lot of doubles and triples and not many strikeouts.” “We didn’t have the billion dollar hit, although there were one or two of those.” I believe that the change in the success rate that Draper describes is a natural outcome of increasing competition in the venture capital business. Since risk capital was relatively scarce in the early years the financial returns in venture capital could be excellent even without finding what Draper calls “the billion dollar hit.” As venture capitalist skill levels and capital under management rose over the years, venture capitalists found themselves needing to find new undiscovered sources of value as the obvious bargains disappeared. This process is similar to what happened to value investing when after a period of years after the end of the Great Depression the obvious “cigar butt” bargains disappeared. Venture capital like value investing was forced to evolve. As an analogy, in value investing the change took the form of people like Phil Fisher and Charlie Munger starting to consider quality in assessing whether a bargain was present. In the venture capital industry, Doriot’s massively successful investment in DEC provided a huge clue about where to find undiscovered and undervalued opportunity. What venture capital industry learned from the financial outcome of DEC was that convex payoffs (nonlinear payoff properties that create massive potential upside and small potential downside) which benefit from uncertainty and disorder could generate very attractive financial returns. A portfolio approach was required in venture capital since only a very small number of outsize winners determine the financial outcome of a given fund. Warren Buffett describes the strategy adopted:

“If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments.  Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities.  Most venture capitalists employ this strategy.  Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.”

By investing in businesses that can generate convex payoffs venture capitalists have been able to generate the returns we see in venture capital today. Because payoffs from convex propositions are determined by complex systems financial returns in modern venture capital reflect a power law distribution. Draper is saying that this was not the case in in the early years.  My thesis is that investments like ARD made in DEC fundamentally changed the venture capital business. Draper has his own theory on why there were less failures in the early years, but I just don’t see it as being sufficient to drive the magnitude of the change. He said:  “I think the reason [for fewer failures] is we’d share deals with other venture firms, so that you check your judgment, you get your broader contacts, you get more information, and you have a more cooperative spirit.  It was a lot less competitive than it is today.  Today, there’s these huge companies, and they want to get it all because they’re very hungry.  ‘Feed me, feed me, feed me!;  So that’s something that has changed.  But “The size and the lack of cooperation among venture capitalists [has changed]. It’s hard for them to get a 10 million dollar deal and divide it up and say to Sutter Hill or Sequoia, why don’t you take half of it? We used to do that all the time.” Of course, Draper was actually there and I was not. So you might want to believe his thesis is right instead of mine.

There is one more important point to make that is relevant to what Draper said above abut a lower failure rate in the early years.  In the United States there are only about 3,600 startups a year (~800 per quarter) that obtain first time venture capital from a professional investor. That leaves about 280,000 other startups every quarter that need to either raise some form of capital or bootstrap themselves financially. There is room for many other business financing models including what some call “Indie VC” and other approaches that involve cash flow financing like merchant based finance from a factor. Cash flow based financing is available and has a cost that varies with the approach. But it is  not “disruptive” to venture capital.

 

  1. “For every hundred entrepreneurs, we say yes to four or five. Saying no is the worst part of the job.” Finding a venture capital investment that has the requisite amount of convexity (huge potential upside and small potential downside) is a bit like looking for a needle in a haystack. A venture capital firm may look at thousands of different investments before deciding to invest in as few as two to five businesses a year. Marc Andreessen points out: “the basic math component is that there are about 4,000 startups a year that are founded in the technology industry which would like to raise venture capital and we can invest in about 20. We see about 3,000 inbound referred opportunities per year we narrow that down to a couple hundred that are taken particularly seriously. There are about 200 of these startups a year that are fundable by top VCs.” No one likes to deliver bad news to a founder, but that is part of the job. The venture capitalist does not do the founder any favors if they string them along when they know the answer is no. A founder should realize that hearing the word “no” from venture capitalists is almost always part of the process.

 

  1. “Venture capital was not a word known out here.  It was known to me and my father and a lot of people in New York because of J.H. Whitney and the Rockefellers were known to do some venture capital.  They backed Minute Maid, and Eastern Airlines, but those were both family operations.  I knew it more because of General Doriot who, while he was teaching, was also starting up and running American Research and Development.  AR&D was a venture capital company that made the big mistake of having a public issue, and being a public company, having to answer to stock holders.  [It was a mistake] because in this business it’s just not earnings that you can predict.  It’s very blocky, and you don’t really know what the value is of your assets either.  So that combination made it very awkward to be a public company.” I have already written a blog post on Georges Doriot and his struggles in creating AR&D. Limited partners who understand that venture investments are not liquid and take a long period of time to pay off are a great luxury for a venture capitalist. The very best limited partners have been involved in venture capital for decades and aren’t doing things like rushing to find a secondary market to unload their holding in the events the market turns negative. Venture capital has always been a cyclical business. Limited partners who can ride out the down cycle end up with superior financial returns as a reward for their patience. A venture capitalist who has experienced and thoughtful limited partners will be better at his or her job since they will not be distracted as much by the antics of nervous limited partners.

 

  1. “I consider all characteristics of success, but it’s the CEO, the entrepreneur, that’s the most important among all the factors.” Great people, attractive markets and significant innovation are all required for a business to become a success. Different founders and venture capitalists put different emphasis on these three elements of success at different stages of the evolution of a business. Robin Richards, who co-founded Draper Richards Kaplan with Draper once said: “You’ll find that other investors tend to ask whether the market makes sense and that people are interchangeable. Bill will take on business risk. He doesn’t want to take on people risk. He wants to make sure he can really work with that person or people. That’s what makes Draper unique. He’s always been about the people.” In this way Draper is more like Pitch Johnson and Eugene Kleiner when it comes to people. He would rather take on market risk or technical risk that people risk. Of course, risk and problems related to people can appear to be low at first and then appear as the business evolves. One interesting thing about the rise of software-based business models is that it is not nearly as common today for technical risk to be the primary concern of investors and founders. As a result, most of the risk that a founder must retire is now market risk, if you get the people issues right.

 

  1. “The entrepreneurial mind is an inquisitive mind.” I rarely meet a founder who is not a curious person and successful founders who are not curious are even rarer. I have also found that inquisitive people inevitably like to read. Not only do they like to read, but they read broadly. The best founders typically ask great questions and love to learn. Successful founders also tend to have strong opinions that are weakly held (they believe in what they believe because they have done the research to feel that way but can quickly adapt if new evidence becomes available). Eric Ries talks about why an inquisitive mind is so valuable in a founder: “As an entrepreneur everything you do – every action you take in product development, in marketing, every conversation you have, everything you do – is an experiment. If you can conceptualize your work not as building features, not as launching campaigns, but as running experiments, you can get radically more done with less effort.”

 

  1. “Venture capital is not all about money, it’s really mostly about building a company with the entrepreneurs who do the heavy lifting.” Implicit in this statement by Draper is that the best venture capitalists help with “light lifting.” Different venture capitalists and firms have different models for how much support they provide to portfolio companies. Venture capitalist support can range from:  (1) extensive support from so-called platform approaches which offer end-to-end support (public relations, marketing, finance, recruiting, sales, distribution etc.) to (2) lighter touch support where the VCs get involved in only a few issues like recruiting or scaling growth in addition of their board duties. For example, Chamath Palihapitiya has a system where: “our growth team can help them implement the right data infrastructure, implement the machine learning, implement the right sort of customer acquisition metrics and reporting.” Other venture capital firms have full time recruiters on staff. A first time technical founder will have different needs than an experienced founder, so that there is a range of available venture capital options for founders to choose from is a good thing. Marc Suster writes that a founder should: “Beware of VC Seagulls, who shit on you and then fly away (or worse yet leave you with Red Herrings).  The best VCs act as a sounding board for management.”

 

  1. “When an entrepreneur has a first board meeting, we called that the ‘Oh shit meeting.’ That’s when the VC finds out the bad news he didn’t know when he made the investment. How the VC reacts to that defines the relationship – it either becomes more brittle or closer.” Honesty is important in any relationship. Not only is honesty the right policy morally but it is vastly more efficient. Charlie  Munger puts it this way: “You’ll make more money in the end with good ethics than bad. Even though there are some people who do very well, like Marc Rich – who plainly has never had any decent ethics, or seldom anyway. But in the end, Warren Buffett has done better than Marc Rich – in money – not just in reputation.” Being ethical and honest is good business and in addition a necessary part of being a good person. Of course, sometimes problems are discovered that have nothing to do with a lack of honesty. A venture capitalist in a board meeting or otherwise may discover things that the founder(s) do not realize are a significant problem. Helping to resolve those problems is part of being a valuable board member. Since relationships like this tend to be both long in duration and intense, strong relationships can be formed just as they do during other life changing events like college or the military. The venture capitalist-founder relationship is sometimes said to be like a marriage, except it is harder to get a divorce.

 

  1. “Very often [Founders] overestimate the size of the market that their product or service will reach and underestimate what it takes in the way of a timeline (and) a team. Sometimes they make the mistake of thinking they can do everything themselves.” “We often tell (entrepreneurs) they have underestimated the timeline – toward becoming profitable or becoming an exit candidate, for example. They’d say, ‘No, we’ve doubled the time we think it will take.’ Then we double that timeline, and very often that’s not enough.” If founders were not optimistic and confident they would not be founders. For example, founders would not be able to withstand the many critics who will inevitably say that are crazy. As a result of this optimism and confidence Draper is saying that founders may get ahead of themselves a bit and the board’s job in part is to make their estimates more realistic without choking off their ambition. This is often tricky. I have written about board members like the late Coach Bill Campbell who understand how to strike the right balance. The best venture capitals are patient. As a result of skills developed via pattern recognition the best venture capitalists can provide excellent guidance of timing and staging.

 

  1. “A great firm name isn’t worth much if the actual partner on your board isn’t very good.”A great venture capital firm is valuable to a founder since several partners are sometimes available to lend a hand if needed. What Draper is saying is that the quality of a board partner within that firm has great importance for a given founder. This is particularly true for the lead venture capital firm or firm involved in a startup since it is often that partner or partners who are critical in helping the firm raise the next funding round. Not having a lead investor just to minimize dilution can be penny wise and pound foolish. A lead investor who will signal to others that the business is a sound investment is invaluable.

 

  1. 11. “[Some founders have] the misconception that things will take care of themselves and that the competition will stay the way it is. Nothing stays the same. So the inflexibility becomes a problem.” The old saying that the only constant is change is true. If a business ever earns a profit or even seems likely to earn a profit competition will inevitably arrive. The ability to successfully adapt to change is part of what makes a great founder and, in and of itself adds, to the convexity of the investment. In other words a great team of people give a business valuable added optionality that is often essential to success given the need to adapt. Draper is saying that he has at times had to encourage founders to be more flexible to respond to competition. Striking the right balance on this set of issues is key, since the founder’s motivation and persistent nature are important to maintain. Sometimes what looks like dogged founder persistence sends a business right off a high cliff and at other times it is the key to success. Knowing the difference between suicidal moves talented differentiation is part of what separates a great venture capitalist from a bad venture capitalist.

 

  1. “Venture Capital started because of Stanford University.” “Without Stanford there would be no Silicon Valley. There’s just lots of structural support in Silicon Valley.” Generating strong economic growth in ant region of the world requires a major research university as an anchor.  There is no substitute in a modern economy for this engine of growth. If you look at which areas of the world are economically successful, you inevitably see at least one major research university. If a given city or region does not have a major research university it should try to affiliate with a city that does. Silicon Valley not only has Stanford but Berkley and UC San Francisco. Of course, there are range of other support services that a region must have to generate successful technology businesses. When all of the necessary factors come together any given city may find itself having significant success but it is not likely that it will be another Silicon Valley, but rather it will find its own version of success. I have written about this topic previously:   http://www.geekwire.com/2016/12-things-seattle-can-teach-others-jobs-economic-development-building-better-city/

 

Notes:

The Startup Game: Inside the Partnership between Venture Capitalists and Entrepreneurs  https://www.amazon.com/Startup-Game-Partnership-Capitalists-Entrepreneurs/dp/023010486X?ie=UTF8&tag=bisafetynet-20

Interview http://www.aaa.si.edu/collections/interviews/oral-history-interview-william-f-draper-12973

HBS Interview http://www.hbs.edu/entrepreneurs/pdf/bill.draper.pdf

WSJ Interview: http://blogs.wsj.com/venturecapital/2011/01/12/bill-draper-takes-stock-of-a-venture-capital-industry-he-helped-create/

Interview transcript: http://bancroft.berkeley.edu/ROHO/projects/vc/transcripts.html

Fortune: http://fortune.com/2011/01/21/qa-with-bill-draper-on-venture-capital-startups-and-skype/

Video: http://www.valleyzen.com/2008/07/08/bill-draper-draper-richards-exclusive-video/

A Dozen Things I’ve Learned from Andy Grove about Business and Strategy

 

“Andrew S. Grove was born in Budapest, Hungary in 1936. He graduated from the City College of New York in 1960 with a Bachelor of Chemical Engineering degree and received his Ph.D. from the University of California, Berkeley in 1963. Upon graduation, he joined the Research and Development Laboratory of Fairchild Semiconductor and became Assistant Director of Research and Development in 1967. In July 1968, Grove participated in the founding of Intel Corporation. In 1979 he was named President, and in 1987 Chief Executive Officer.”

 

  1. “Success breeds complacency. Complacency breeds failure. Only the paranoid survive.” “I believe in the value of paranoia. Business success contains the seeds of its own destruction. The more successful you are, the more people want a chunk of your business and then another chunk and then another until there is nothing left.” Grove believed that some degree of fear is healthy for any business, especially if the businesses has been successful. Two business school professors who have studied Grove point out: “A touch of paranoia—a suspicion that the world is changing against you — is what Grove prescribes.” The Economist magazine describes Grove’s application of what one might call a “paranoia principle” as follows: “[Grove] argues that every company will face a confluence of internal and external forces, often unanticipated, that will conspire to make an existing business strategy unviable. In Intel’s case, such a ‘strategic inflection point’ arose because its memory-chip business came under heavy assault from new Japanese rivals willing to undercut any price Intel offered.” Strategic inflections points are created when a business faces an order-of-magnitude change in their environment. The two professors argue: “Grove offers a ‘six forces’ framework for identifying strategic inflection points. He starts with Michael E. Porter’s five-forces model: customers, suppliers, competitors, potential competitors, and providers of substitutes. He then adds complementarity to the strategy map.” Grove wanted to be sure that if there was the potential for convex outcomes Intel would be well positioned to benefit and if there was the potential for a concave outcomes Intel would be well positioned to avoid harm. Grove identified a range of factors he worried about in in his book Only the Paranoid Survive: “I worry about products getting screwed up, and I worry about products getting introduced prematurely. I worry about factories not performing well, and I worry about having too many factories. I worry about hiring the right people, and I worry about morale slacking off. And, of course, I worry about competitors.” Grove recognized that competitors will inevitably be attracted to any source of profit and that increasing competition will drive returns down toward the opportunity cost of capital. What was once profit (producer surplus) is inevitably eventually transformed by competition into consumer surplus. This shift of value from producer to consumer is now new. What is new since the arrival of Moore’s law and the proliferation of digital networks is how fast this transformation of profit into consumer surplus happens. It is increasingly hard for any business to maintain pricing power in the face of (1) technological progress and (2) intense and rising levels of global competition. Companies are finding it hard to meet their investment hurdle rates give this phenomenon and so cash often piles up or is distributed rather than being reinvested.  People involved in a real business know that innovation often reduces rather than increases profit. Consumers always benefit from innovation but GDP may actually shrink as a result of the innovation. Charlie Munger put it this way once: “There are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.” The point here is simple: some innovations create a moat due to the presence of factors like network effects and some innovations destroy moats. More consumer benefit is wonderful for society, but so is some healthy level of producer surplus since this is what powers a healthy growing economy.

 

  1. “Technological change is going to reach out and sooner or later change something fundamental in your business world.” Once upon a time there was a distinction between technology businesses and other businesses. Today every business is a technology business. As a result if this shift, a technological change can quickly create a strategic inflection point for any business. For example, John Deere is no longer a supplier of farm equipment but rather a provider of integrated productivity solutions for agriculture. Ford is no longer just a supplier of automobiles. Companies like John Deere and Ford increasingly find themselves in competition with other businesses that they never thought of before as competitors and also as partners with firms that they never though they would partner with. The wrong response to a strategic inflection point proved to be the undoing of companies like Kodak, Nortel and Motorola. The right response can create powerful new sources of profit for a business.

 

  1. “If existing management want to keep their jobs when the basics of the business are undergoing profound change, they must adopt an outsider’s intellectual objectivity. They must do what they need to do to get through the strategic inflection point unfettered by any emotional attachment to the past.” “I do have a lot of strong feelings. When it gets to one of those, I guess I state them pretty forcefully. I don’t thrash out and yell (but) maybe some people think it sounds like yelling.” Grove believed in “constructive confrontation.” To put it bluntly, an encounter with Grove was often intense. He wanted issues brought out into the open, fully discussed and decisions made in a very timely way. In an interview in Chicago Tribune in 1996 he said: “We encourage our people to deal with problems without flinching. At its best, the method means that people deal with each other very bluntly.” I am quite familiar with business discussions reflecting this level of intensity. I have been in numerous meetings in which the people involved argued their positions so vociferously that spittle was flying back and forth across a conference table. I see less of this behavior than I did in the 1980s and 1990s but it still happens sometimes. What most people do not understand about meetings like this is that after the issues have been “fully and candidly discussed” the people involved are capable of making a decisions at the conclusion of the meeting and the doing something like getting hamburgers together as if the intense confrontation never happened. It also surprises some people to learn that when someone important in the technology industry says nothing when you are making a presentation it can mean that they think you are an idiot. In technology, it is often the case that the more someone confronts what you are saying the more they may believe what you are saying is important or interesting. If you are not familiar with this bluntly confrontational environment, it can be disconcerting. As just one example, Larry Ellison and Steve Jobs were at a dinner once in which Grove said he would not have hired either of them since they were “flakes.” Ellison recalls: “Both Steve and I admired and respected Andy. We enjoyed all of our precious time with him, including the memorable and characteristic abuse.” I am not saying that all technology managers are confrontational. I worked for many years for Craig McCaw and he was the polar opposite of Grove when it came to blunt confrontations. Craig McCaw is the politest and most private person I have ever known. He just has a different style than someone like Grove. What McCaw and Grove do share is mastery at confronting their own ideas. This self-confrontational approach can be an effective way to deal with: (1) confirmation bias and (2) avoiding situations where the CEO does not hear the truth since his or her staff is unwilling to deliver bad news or push back on the CEO’s opinions. I agree with Charlie Munger that an effective manager or investor knows the other side of the argument better than the people who he or she disagrees with. Since most mistakes are psychological or emotional, attachment of these factors to the past is banished by the most effective managers since that baggage is what an accountant would refer to as “sunk.”

 

  1. “Intel [is] a data driven company and the phrase is, ‘Don’t argue with the emotions, argue with the data.’” “Measurement against a standard makes you think through WHY the results were what they were. Former Intel executive Pat Gelsinger said once: “If you went into a meeting [with Grove], you’d better have your data; you’d better have your opinion; and if you can’t defend your opinion, you have no right to be there.” Grove joked at his last shareholder meeting about his drive to obtain the very best data: “I didn’t enjoy myself 100 percent of the time. According to my statistical analysis, it was about 80 percent.” The amount of data that is available today is unprecedented and modern machine leaning tools that can analyze that data are evolving at a breakneck pace. Grove was an admirer of other businesses that have learned to use data well, For example, he said once:  “Amazon is the preeminent pioneer in building a new way of doing commerce: personalized, database-driven commerce, where the big value is not in the purchase fulfillment, but in knowing as much about a customer base of ten or twenty million people as a corner store used to know about a customer base of a few hundred. In today’s mass-merchandising world, that’s largely gone; Amazon is trying to use computer technology to re-establish it.” Moats are increasingly resulting from the ability of a business to apply analytics to the data that their business generates. There is a feedback loop at work: the more successful a business is the more data they generate, the more successful that the business is [repeat].

 

  1. “Most companies don’t die because they are wrong; they die because they don’t commit themselves. They fritter away their momentum and their valuable resources while attempting to make a decision. The greatest danger is standing still.” That decisions get made in a timely way as part of Grove’s “constructive confrontation” is critical. Eugene Kleiner once said: “The more difficult the decision, the less it matters what you choose.” What Grove and Kleiner mean is that sometimes you are better off making a decision and living with it than agonizing over the decision for a long period and as a result experiencing a significant delay. What can kill a shark is when it stops moving in the water and a business today can be killed in much the same way. Business momentum matters since feedback effects are so powerful. If competitors harness new network effects or other phenomena while a business is unable or unwilling to make a decision, the result can be very harmful or even deadly.

 

  1. “I think it is very important for you to do two things: act on your temporary conviction as if it was a real conviction; and when you realize that you are wrong, correct course very quickly.” “Investment decisions and personal decisions don’t wait for the picture to be clarified.” “It’s not that you shouldn’t plan but you should not regard your plans to be anything more than a baseline model of what might happen.” This point made by Grove is consistent with the “strong opinions, loosely held” idea that I have written about before. We all face a world filled with risk, uncertainty and ignorance. The best approach is to have strong opinions that reflect the best research and data possible, but that can be changed as new and better data becomes available. The world is more connected every day by digital networks and this creates phenomena that feed back on themselves which creates unpredictable turbulence. Outcomes are much more likely to be determined by genuinely complex processes than in the past. In other words, the world will evolve in ways that many businesses will not anticipate since the business environment is increasingly nonlinear. If a business is not preparing for this level of change to increase in both scope and magnitude, it may get caught in a turbulent riptide of change and find its business battered or even destroyed.

 

  1. “You need to try to do the impossible, to anticipate the unexpected. And when the unexpected happens, you should double the efforts to make order from the disorder it creates in your life. The motto I’m advocating is — Let chaos reign, then rein chaos. Does that mean that you shouldn’t plan? Not at all. You need to plan the way a fire department plans. It cannot anticipate fires, so it has to shape a flexible organization that is capable of responding to unpredictable events.” “There are two options: adapt or die.”  Dwight Eisenhower is famous for saying: “In preparing for battle I have always found that plans are useless, but planning is indispensable.” Survival in the long term is determined by adaptability, rather than size or strength. Using the preparation process to get ready to change that will produce surprising and sometimes shocking outcomes is wise. Expecting to be able to successfully respond to change by pulling out a prepared plan is a triumph of hope over experience.  Denial is not just the name of a river in Egypt, it is the leading cause of the death of businesses.

 

  1. “The new environment dictates two rules: first, everything happens faster; second, anything that can be done will be done, if not by you, then by someone else, somewhere.” A digital connected world is an accelerated world. Everything moves faster now due the advance of technology and networks. Everyone has better information and that information is dispersed faster than ever and so any advantage a business has that is merely better operational effectiveness can be copied far quicker. The speed at which a new competing business can be created has never been faster. The ability of businesses to compete from half way around the world has never been easier. Accelerating these phenomena even more is that fact that capital for genuinely good idea is not scarce. As Professor Michael Porter points out, operational effectiveness is very important, but it is not a strategy. Strategy is about what a business does differently than its competitors to create a sustainable competitive advantage. What does your business do differently that will create what Warren Buffett calls a moat against competitors? If you have a moat it is more valuable than ever since they are scarce, but also more at risk that ever before too.

 

  1. “Long distances used to be a moat that both insulated and isolated people from workers on the other side of the world. But every day, technology narrows that moat inch by inch. Every person in the world is on the verge of becoming both a coworker and a competitor to every one of us.” “You have no choice but to operate in a world shaped by globalization and the information revolution.” Moats have never been under more threat. Globalization and innovation have never been stronger as driver of change. The impact of globalization is taking a front seat in the world of policy and business today. Some people are now arguing that globalization has gone too far. The reality may be, however, that it may not be possible to put that genie fully back in the bottle. Since globalization is to some degree here to stay no matter how the political environment  changes, many aspects of society will need to be rethought as a result. The idea that the world can change as quickly as it is now, but that societal institutions can stay the same is unrealistic. This is equally true for a business.

 

  1. “You have to understand what it is that you are better at than anybody else and mercilessly focus your efforts on it.” Comparative advantage is the ability of an individual or group to engage in a particular economic activity (such as manufacturing a product or writing software) more efficiently than another activity. Professor Michael Porter argues “the essence of strategy is choosing a unique and valuable position rooted in systems of activities that are much more difficult to match.” Grove is saying that a business should find this comparative advantage and FOCUS resources on it with passion. Business that try to do everything end up doing close to nothing. Grove said once on this point: “A question that often comes up at times of strategic transformation is, should you pursue a highly focused approach, betting everything on one strategic goal, or should you hedge? Mark Twain hit it on the head when he said, Put all of your eggs in one basket and WATCH THAT BASKET.” As Mark Cuban has said you can’t diversify your way into knowing what you are doing.

 

  1. “The Internet doesn’t change everything. It doesn’t change supply and demand.”  Charlie Munger made a similar point when he said the Internetincreases efficiency, but lots of things increase efficiency without increasing profits. It is way more likely to make American businesses less profitable than more profitable. This is perfectly obvious, but very little understood.” Without a moat against competition that places some limits on the supply of what you sell, profit will not arrive. Warren Buffett said at the last Berkshire shareholder meeting that microeconomics defines what a business is and the Internet does not change the fundamentals of microeconomics. Grove has said on this point of microeconomics: “There is a time-dimension involved in the adjustment of one system to another. And by the time a supply-and-demand imbalance develops in one area of the economy, you can be very much out of phase with what is happening elsewhere. In physics, the equivalent would be unstable oscillations; in medicine, it would be heart palpitations. Economists don’t bother with that. They take one picture in a steady state, and another picture in a steady state, and somehow they think nature will smooth everything out. Often it does, but just as often it does not.”

 

  1. “Technology will always win. You can delay technology by legal interference, but technology will flow around legal barriers.” “Technology happens, it’s not good, it’s not bad. Is steel good or bad?” Technology will always find a way to route around obstacles. It is a question of when barriers to the adoption of technology will be circumvented not whether it will happen. Technology itself is morally agnostic. Society must learn to use it in ways that are beneficial. William Gibson agrees with Grove on this point: “I think that technologies are morally neutral until we apply them. It’s only when we use them for good or for evil that they become good or evil.”

 

Notes:

Only the Paranoid Survive  https://www.amazon.co.uk/Only-Paranoid-Survive-Andrew-Grove/dp/1861975139

High Output Management  https://www.amazon.com/High-Output-Management-Andrew-Grove/dp/0679762884

Grove Essay:  http://www.intel.com/pressroom/archive/speeches/ag080998.htm

Interview with his biographer: http://hbswk.hbs.edu/item/the-history-and-influence-of-andy-grove

Inside Intel:  https://hbr.org/1996/11/inside-intel

Quartz: http://qz.com/645327/silicon-valleys-confrontational-management-style-started-with-andy-grove/

Economist: http://www.economist.com/node/14299624

 

A Dozen Things I Learned Being Involved in one of the Most Ambitious Startups Ever Conceived (Teledesic)

 

 

I’ve decided to write this blog post about one of the more interesting business stories that has never really been told accurately. The story started for me when I was hired in 1994 to join a company that would become known as Teledesic as the fourth employee. This startup’s mission was to provide communications to the world regardless of location. Early in the process of designing the system it become evident that the nature of the available spectrum when combined with the greatest market need meant that it should be focused on providing broadband communication and not just telephony services. I had been involved in the mobile industry since the 1980s and knew the power of communications to make people’s lives better. So the mission of the startup was very appealing to me.

Craig McCaw and Bill Gates were the founding shareholders of the company, but were not involved in the day-to-day business of the company. My friend Russ Daggatt was the second employee to join the company and Elaine Ferguson was our co-conspirator. We started Teledesic in a couple of furniture cubes in the offices of what was then McCaw Cellular (it was sold to AT&T two years later). We had nothing really at the start but a modest amount of cash, our chutzpah and the reputations of our founding shareholders. Teledesic’s plan was audacious: build and operate more active satellites than any other previous satellite constellation – originally the plan was for 840 active satellites (reduced to 288 satellites in 1997). The original estimate of the system cost before any service could be provided was $9 billion. The idea for Teledesic was a spinoff of a military system called “brilliant pebbles.” Ed Tuck originated the idea for Teledesic, but it had been shepherded by the first employee, an engineer named Dave Patterson. There were many other very talented people involved in Teledesic that I could name but this is a short blog post not a book (which I may write some day). Some people involved Teledesic may disagree with aspects of this post since experiences like this are a bit like the famous Japanese movie Rashomon by Akira Kurosawa. If you have seen that movie you know it is about different people recalling contradictory versions of the same intense collective experience.

I turned down an offer of a very attractive job Microsoft the day I joined Teledesic in 1994. That day I told Bill Gates that I felt a need to do an ambitious startup sometime in my life and that I was passionate about making Teledesic happen. He said he understood why I turned down the Microsoft job, but he probably thought I was nuts. Not too nuts though, since he was an founding investor in what I was about to do. I have written before on this blog that the ideal venture investment is “half nuts” so it has the requisite convexity to create the potential for a 50-1,000x financial return. I also have written many times on this blog that missionaries act differently and are willing to do more things to make a startup successful than mercenaries. From 1994 until 1999 I threw my life into making Teledesic’s business a reality. You probably have heard the story about the chicken being involved in breakfast because she laid an egg but that the pig was committed to breakfast since he supplied the bacon. Investors are like the chicken, but startup up employees are like the pig. I flew over 500,000 air miles a year for five straight years to help retire Teledesic’s financial, regulatory and technical risk. I worked constantly. Other Teledesic employees where working just as hard accomplishing  impressive things on the technical, business and regulatory aspects of the business. An amazing multi-disciplinary team was assembled in Kirkland, which is a suburb of Seattle. If I name one more of these people I would feel compelled to name them all.

Based on the incredibly positive reputation of our founding shareholders we were able to meet with just about anyone on earth in developing Teledesic. People I met with around the world inevitably would look at me dumbfounded as I told them about a constellation of hundreds of satellite circling the Earth providing broadband service. The New York Times once called the number of satellites involved in the Teledesic system design “mind boggling.” But since Craig McCaw and Bill Gates were involved most of these people not only listened but decided to get involved. The arc of the startup’s existence coincided with the Internet bubble so we had a tailwind that enabled us to plan to make fantastic things happen.  The business climate for new ventures like Teledesic started to get even more positive when the Mosiac browser was released on November of 1993. After Netscape went public in August of 1995 the business and investing climate in the technology world started to get euphoric. Raising the $9 billion needed to build the system seemed more possible every day.

Like any startup that is worthy of venture capital Teledesic had all the elements of “the struggle” for the team trying to make it happen. Sleepless nights. Worries. Things going right and wrong. When I talk to a founder, my experiences at Teledesic color my world view and advice. Ben Horowitz describes the struggle involved in a startup beautifully:

“Your product has issues that will be very hard to fix. The market isn’t quite where it was supposed to be. Your employees are losing confidence and some of them have quit. Some of the ones that quit were quite smart and have the remaining ones wondering if staying makes sense. You are running low on cash and your venture capitalist tells you that it will be difficult to raise money given the impending European catastrophe. You lose a competitive battle. You lose a loyal customer. You lose a great employee. The walls start closing in. Where did you go wrong? Why didn’t your company perform as envisioned? Are you good enough to do this? As your dreams turn into nightmares, you find yourself in The Struggle.”

There were many things to worry about at Teledesic. We faced technology risk, financial risk and market risk. The experience was exhilarating and frightening at the same time. Teledesic did not have the support of everyone in the orbit of the founders in the early days. At one point when the startup had only had seven employees an executive named Wayne Perry who had worked with Craig McCaw for many years in the mobile and cable businesses said: “The problem with Teledesic is Russ and Tren – they just won’t let it fail.” Wayne was not a fan Teledesic in its early days, but many other people were fans. People in general love space-based businesses. Who doesn’t marvel as they look up at the sky on a clear dark night?

Through sheer force of will, the reputation of the founding shareholders  and a lot of work, the small but growing team at Teledesic took the business forward clearing regulatory and other hurdles that others thought would certainly kill us. The peak of achieving the impossible was in 1995 when we achieved a regulatory win thought unwinnable at a World Radio Conference in Geneva. What we did in about six weeks in Geneva was simply unheard of in regulatory circles. Wired magazine wrote at the time:  “It was a giant party, complete with favors,’ said an executive at wireless phone company Qualcomm, who, like seven other attendees of the 1995 conference interviewed by Wired News, talked about the conference on the condition of anonymity. These seven echoed the accounting of events at the WRC ’95. Other delegates remembered it differently – as a lobbying effort never before seen at a World Radio Conference. ‘What was unprecedented, I believe, was the scale and systematic aspect of this lobbying effort,’ noted a French delegate.” We were pirates with an entertainment budget and modern communications tools like the Internet and mobile phones. I loved being a pirate. It is about as much fun as you can have with your clothes still on.

By the fall of 1998 other opportunities were proliferating in the business world and I was asked by Craig McCaw to become more involved in other aspects of his communications and software businesses. By 1999 I was only involved in Teledesic as an advisor. By then the Internet bubble was in near full swing with lots of interesting and challenging things to do in private equity and venture capital.  A talented team was in place at Teledesic to take it forward so I felt relatively good about moving on. I did have one major nagging concern. Giant companies like Boeing and Motorola were getting involved as Teledesic contractors and that meant space and other systems for Teledesic which kept growing both in terms of size and cost. The involvement of the huge contractors also made being involved in Teledesic less fun.  The days of being a pirate in a startup known as Teledesic seemed to be ending, and were being replaced by traditional processes and thinking typical in giant defense and space companies. One brilliant thing that founders like Elon Musk and Jeff Bezos are doing today with their involvement in space-based businesses is not creating  dependencies on these traditional high cost contractors. To do so would create wholesale transfer pricing problems that would kill their efforts to reduce cost, as I will explain below.

At the time I ceased being a Teledesic employee in 1999 people still believed in the dream especially since by then valuations were skyrocketing daily as people suspended disbelief about many aspects of financing a business. Anything seemed possible during those years, even the idea of raising the needed $9 billion for building the proposed Teledesic satellite system. But about two years later the business climate changed for the worse rather abruptly. People who did not live through the internet bubble simply don’t understand how quickly things changed. One day you could raise billions of dollars to build something like a massive fiber based national or global telecommunications network and the next you could literally not raise 3 cents. Just reading about this shift in the ability of a business to raise new funds is not sufficient to convey how swift the change from internet bubble to internet bust really was. If you went through the internet bubble and its collapse you were forever changed. Your muscle memory is just different than other people who did not have the same experience.

In the end the financial, technical and business risks associated with Teledesic could not be retired. A non-geostationary system must serve everywhere to serve anywhere so the constellation was an all or nothing effort. The ground antennas given technology at the time would have been too expensive and complex given the frequency band (Ka) and the satellite system costs were just not low enough since a cubesat approach was not being adopted. Non mechanical inexpensive antennas at that frequency are still a year away from being available even today. When Teledesic was trying to purchase launch services in 2001 entrepreneurs like Elon Musk and Jeff Bezos were not driving down launch costs and cubesat-style satellite systems were not being built yet since Moore’s law was not quite far enough along. The traditional manufacturers like Boeing and Motorola did not want to enable cubesat-style systems, so cost estimates skyrocketed and satellite size ballooned. The traditional manufacturers wanted to re-use the massive satellites they had already developed so the number of satellites in the proposed system needed to be reduced. These traditional manufacturers did not want cheap satellites since their military and government customers would want them too. They liked the idea of PhDs assembling massive satellites in clean rooms out of custom parts since it created a barrier to entry. I wrote about this price elasticity problem of a legacy manufacturer in my blog post on Elon Musk. Sometimes people will say that the Teledesic system shrunk in size since Boeing or Motorola had a better design. That is bullshit. The proposed Teledesic system shrunk because the legacy satellite manufacturers had huge satellites they already manufactured and they did not want to make small satellites since that would require new engineering and a new business model. Most importantly, the legacy satellite manufacturers did not believe they would sell many more satellites if they were cheaper.

Elon Musk and others like Greg Wyler’s OneWeb satellite system have revived the original Teledesic idea of constellations of hundreds and even thousands of satellites. I am optimistic these systems will get built and become operational. What is different now and what might make it happen? First, Moore’s law has had a couple of turns since then and more is possible at substantially less expensive price points. But more importantly a new group of people have been making very small “cubesats” in ways that some more traditional people involved in space would consider “a toy” These cubesats are tiny and simple by traditional standards and manufactured from off the shelf parts in many cases in a relatively normal manufacturing facility at far lower cost. These cubesats are getting better and better and can be up-sized to bigger dimensions (for example 250 kilograms) to make them powerful enough to do communications and not just imaging. The biggest question I have actually is not whether these system can be built and financed but rather: what is the total addressable market (TAM) for these communications systems given the cost of the services and the the necessary antennas? Is there enough demand and the prices that will be charged to make the business case work financially? The radio frequency bands (Ka and Ku) and distances involved most likely mean the communications systems will be used for communications backhaul. Low frequency LTE on the satellite does make not make much sense (channel bandwidth and structure are completely different). Greg Wyler’s OneWeb is planned for Ku/Ka frequencies and therefore is likely to be a system that will be used as backhaul for mobile cell towers and by big customers like the military. I am skeptical that the pictures of small villages using the system to create direct links to the satellites depict a realistic market scenario, but they do help with regulatory approvals. More communications backhaul in hard to reach areas is good for the world, but these systems are not likely to be an affordable scalable broadband communications end-user solution for ordinary users. Having said that, providing emergency broadband communications capability in areas with problems like epidemics and natural disasters is important. Will backhaul be nearly all fiber and terrestrial microwave or will some satellite satisfy some of the demand? What role can drones play in all of this?  Is there enough other demand from other markets like ships, airplanes, NGOs  and the military to make the systems financially successful? I have opinions on that market demand and approaches like drones, but writing about that topic is not right for a short blog post like this. There is already a risk that you may be getting a little bored with parts of this story. In any event, we will find out about the size of market demand for space-based communications systems soon enough.

During its life, the Teledesic team raised over a billion dollars at a valuation that was as  high as a $3 billion. Teledesic was a triple Unicorn in its time. But when it was determined by the Teledesic board of directors that the business could not retire enough of the financial, technical and business risks to proceed, a decision was made to liquidate and hundreds of millions of dollars were distributed back to shareholders. This distribution of cash back to shareholders was and still is relatively unprecedented since most companies in a similar situation just pivot again and again to new businesses ideas until the cash is all gone. The math of corporate finance meant that early Teledesic investors received a significant multiple as a financial return on their investments even though it was a liquidation. One early investor to this day marvels that he received many times his original investment in a company that never provided service. Shareholders who invested at a higher valuation like $3 billion were not so fortunate.

Winding up any startup is never a happy time, but Teledesic was a valiant effort undertaken by a very talented team that paved the way for other similar systems to be built someday. It was also great fun and a wonderful life experience to be involved in the startup, especially in the early days. As Jeff Bezos wrote recently, “failure and invention are inseparable twins.” Negative results provide knowledge to everyone about what will not be a success. That makes it easier to determine what can be successful. Failures enable us to not only make new mistakes but to create genuine and lasting innovation. If you are not occasionally failing in what you do, you are unlikely to achieve great things.

A Dozen Things I Learned at Teledesic:

  1. It is more fun to be a pirate than join the navy. Pirates know how to break the eggs needed to make the necessary omelet. We broke a lot of eggs.
  2. Most people are not cut out for the startup life. It is not for everyone.
  3. Certain periods in your life are right for being involved in an audacious startup, and other periods are not.
  4. Flying 500,000 air miles a year for five years takes a big physical toll on your body. I still pay a physical price for that time in my life.
  5. Almost everything in life that is technically interesting and important involves trade-offs.  This is especially true in space.
  6. The more great people you hire, the easier it is to hire great people. Positive feedback can be powerful.
  7. The better the quality of your existing shareholders, the easier it is to attract new high quality shareholders.
  8. Having smart, talented and accomplished lead investors is invaluable in raising funds.
  9. Space is very big. The distance to a non-geostationary orbit around the Earth is not so big, but launching any mass into that orbit is still relatively expensive.
  10. There are no electrical outlets or power cords in space. This creates hard problems for systems that need power. 
  11. Since power density of an electromagnetic wave is proportional to the inverse of the square of the distance from a point source, space-based communications isn’t easy.
  12. Billionaires love space and rockets.  A rocket launch is like a big very controlled explosion.  Explosions that are very controlled and hurt no one can be great fun. Billionaires like to have fun.

 

Notes:

Wired on Teledesic:   http://archive.wired.com/science/discoveries/news/1997/10/7655

New York Times on Teledesic: http://www.nytimes.com/2000/06/04/business/can-craig-mccaw-keep-his-vision-of-teledesic-from-crashing.html?pagewanted=all

The Teledesic System: http://3csysco.com/Pubs/Teledesic%20Satellite%20System%20Overview.pdf

The Struggle by Ben Horowitz  http://www.bhorowitz.com/the_struggle

 A Dozen Things I’ve Learned from Mark Cuban About Business and Investing

 

  1. “I’m always selling. Always.” “Learn to sell. In business you’re always selling – to your prospects, investors, and employees. To be the best salesperson, put yourself in the shoes of the person to whom you’re selling.  Don’t sell your product. Solve their problems.” “No sales, no company.” “Make your product easier to buy than your competition, or you will find your customers buying from them, not you.” “Treat your customers like they own you. Because they do.” “Your customers can tell you the things that are broken and how they want to be made happy. Listen to them. Make them happy. But don’t rely on them to create the future road map for your product or service. That’s your job.” Being an effective salesperson is significantly underrated as an important life skill, especially by engineers who too often hope that a great product will sell itself. In thinking about the value of the ability to sell it is wise to remember that people sell much more than just products. For example, you were selling when you received your first romantic kiss. People must sell themselves to a potential spouse or “significant other” person. A business owner not only sells product but the company to employees and distributors. I have a good friend who likes to say that “everyone is talking their book all the time.” This is true and it is clear that some people are much better at talking their book than other people. It has been my experience that the best salespeople don’t even appear to be selling. I had a late friend who people said was such a good salesman that he was capable firing someone and that person would not know they were fired until they were at home that night telling their spouse about their day. “Hey, wait a minute…” On the last point Cuban makes above on future products, he seems to agree with Steve Jobs, who once said in an interview:

Business Week: Did you do consumer research on the iMac when you were developing it?
Steve Jobs: No. We have a lot of customers, and we have a lot of research into our installed base. We also watch industry trends pretty carefully. But in the end, for something this complicated, it’s really hard to design products by focus groups. A lot of times, people don’t know what they want until you show it to them. That’s why a lot of people at Apple get paid a lot of money, because they’re supposed to be on top of these things.

 

  1. “Sweat equity is the most valuable equity there is.” “Everyone has ideas, but most people don’t do the work required to get the job done.” “It’s not about money or connections — it’s the willingness to outwork and out learn everyone.” “You accomplish much more with direct relationships than by using an intermediary.” Sweat equity is not only the cheapest form of equity to acquire, it is the most rewarding as well. But more than just acquiring cheaper equity is going on when you do something yourself since it means you are in the best position to know whether you are getting value and the real cost of the work. A person always has some path loss when they use an intermediary and path loss in not a good idea when a person can benefit so much from having accurate information. Young children are often taught about this idea when they are introduced to “the telephone game” in which a message is passed on in a whisper from person to person. The final version of the message is usually radically changed from the original after the person to person whispering is done, which teaches the lesson. If you always use a vendor to accomplish a task you may never fully know what is actually happening in your business. As an aside, when I say “path loss” in this context I am not referring to the reduction in power density of an electronic wave as it propagates through space. I refer to messages getting garbled when they travel from person to person.

Your Memory is like the Telephone Game: “A memory is not simply an image produced by time traveling back to the original event — it can be an image that is somewhat distorted because of the prior times you remembered it,” said Donna Bridge, a postdoctoral fellow at Northwestern University Feinberg School of Medicine and lead author of the paper on the study recently published in the Journal of Neuroscience. “Your memory of an event can grow less precise even to the point of being totally false with each retrieval.”

 

  1. “Whatever business you have, there is always someone trying to put you out of business.” “Business is a 24/7 job where someone is always out there to kick your ass.” Cuban’s point captures the essence of what Joseph Schumpeter called “creative destruction.” Other businesses are always out there trying to take your customers with a better product offering or a better a sales approach. This process that Schumpeter described is the engine of capitalism and results in the continual transformation of producer surplus to consumer surplus. This transformation process is happening faster than ever, which weirdly has caused some economists to believe innovation has slowed since producers surplus growth has slowed. Anyone who is actually engaged in business knows that the idea that innovation has slowed is completely detached from reality. Current business conditions are more competitive than ever. If you do not have a moat to prevent someone from capturing your customers, your profit will quickly disappear. Competition takes many forms and comes from many places. Harvard Business School Professor Michael Porter teaches his students competition can come from many sources such as customers, suppliers, potential entrants, and substitute products. Be careful out there…

 

  1. “Most people think it’s all about the idea. It’s not. Everyone has ideas. The hard part is doing the homework to know if the idea could work in an industry, then doing the preparation to be able to execute on the idea.”  I doubt there many people above the age of 12 who have not said at least once when they see a successful business: “Hey, I thought of that idea first.” There is a vast gap between thinking about a business and actually doing what is needed to create the business and make it a success. If you are not willing to do the work and take risk nothing will ever be more than an idea. The ability to execute on an idea much rarer than people imagine. Cuban is saying that people who do the preparatory work first and avoid “fire, ready, aim” are much more likely to be successful in life. This point made by Cuban reminds me of Benjamin Franklin who famously once said: “By failing to prepare, you are preparing to fail.”

 

5. “Focus on finding big problems.” A business that serves a big attractive market is much more likely to be a success.  Many businesses fighting over a niche market is not a pretty sight. The venture capitalist Eugene Kleiner said once that a few businesses fighting over a niche market is similar to a few bald men fighting over a comb. Cuban’s point reminds of of one of my favorite Gary Larson Far Side cartoons which involves two spiders sitting next to a playground slide with a spider web stretched across the bottom. One spider is saying to the other spider in the caption: “If we pull this off we’ll eat like kings!” Thinking big pays big dividends when operating a business.

 

  1. “Don’t start a company unless it’s an obsession and something you love. If you have an exit strategy, it’s not an obsession.” If you are missionary and not a mercenary the probability that you will create a successful business goes way up. You will work harder and survive the tough times far better if you love what you are doing and are obsessed with the business. Missionaries are not thinking much about exit strategies since their focus is on getting the job done and achieving their objectives. Which reminds me of  joke.  Two missionaries were captured by a tribe of hostile cannibals who put them in a large pot of water after building a huge fire under it. A few minutes later, one of the missionaries started to laugh uncontrollably. The other missionary could not believe what he was hearing and said: “What’s wrong with you? We’re being boiled alive! They’re going to eat us! What could possibly be funny at a time like this?” The other missionary responded, “I just peed in the soup.” This joke has nothing to do with starting a business, but it is funny and involves missionaries.

 

  1. “[Diversification] is for idiots.” “You can’t diversify enough to know what you’re doing.” Warren Buffett is agreeing with Cuban when he says: “Risk come from not knowing what you are doing.” Buffett believes: “concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as “the possibility of loss or injury. …You only have to do a very few things right in your life so long as you don’t do too many things wrong.” Of course, if you don’t want to do the work to “know what you are doing,” then diversity. Dumb or lazy money becomes smart money when people realize that they are dumb or lazy.  A person’s got to know his or her limitations, as Dirty Harry famously said. Some people are hard working and thoughtful in the rest of their life but lazy and not thoughtful when it comes to investing. They spend more time picking out a shirt in a store than on selecting their investments and their investing results reflect that emphasis.

 

  1. “In every job, I would justify in my mind, whether I loved it or hated it, that I was getting paid to learn and every experience would be of value when I figured out what I wanted to do when I grew up. It is time to get paid to learn.” Until you get out of college you are usually paying to learn. Or at least someone like your parents is paying for you to learn. But after you graduate from college your goal should be to be paid by other people to learn. The more you learn in a given job, the more valuable that experience will be for you and the more other people will want to pay you to learn more.  This is an example of a positive feedback loop and my own life is an example. I have been paid to learn my entire career since I left graduate school. The more I learned in life, the more people have wanted to pay me to learn more so I can help them solve problems and find new opportunities.

 

  1. “When you’ve got 10,000 people trying to do the same thing, why would you want to be number 10,001?” “What I do know, at least what I think I have learned from my experiences in business, is that when there is a rush for everyone to do the same thing, it becomes more difficult to do. Not easier. Harder.” Competition drives down prices to levels where financial return is equal to the opportunity cost of capital. That is the essential truth of capitalism and its engine. The goal in any business is to create some non-replicable advantage that is a moat against competition. Barriers to entry should be the goal of any business.  The deeper and stronger the moat the happier the business owner will be with their financial results. Finding a source of differentiation is a beautiful thing. Harvard Professor Michael Porter puts it this way: “It’s incredibly arrogant for a company to believe that it can deliver the same sort of product that its rivals do and actually do better for very long.”  If you deliver the same product or service as your competitor you by definition don’t have a moat.  Competition will in that case be based on price and price-based competition inevitably degrades to a point where profit disappears.   Porter teaches:  “If customers have all the power, and if rivalry is based on price… you won’t be very profitable.” He adds: “Producing the highest-quality products at the lowest cost or consolidating their industry is trying to improve on best practices. That’s not a strategy.” Cuban is making an additional point here about how a crowded market for X, makes achieving X harder and not easier.  Resources become more scarce when there is a so-called crowded trade going on.

 

  1. “It doesn’t matter how many times you have failed, you only have to be right once.” Michael Mauboussin elaborates on the point Cuban is making: “In any probabilistic exercise: the frequency of correctness does not matter; it is the magnitude of correctness that matters.” This is the so-called Babe Ruth effect. Mauboussin writes: What is striking is that the leading thinkers across varied fields — including horse betting, casino gambling, and investing — all emphasize the same point.” Chris Dixon has a great post on this that I link to in the notes. Dixon points out: “The Babe Ruth effect is hard to internalize because people are generally predisposed to avoid losses.” If you can overcome this loss aversion and learn to benefit from convexity (big potential upside, small potential downside), you can beat the market averages. Doing this successfully is relatively simple concept to understand, but is not easy to do since most mistakes are emotional or psychological. I have said before I think ~10% of people are capable of beat the market but only ~3% are willing to do the work to actually do so. The problems are in no small part created by the fact that more than half of investors think they are in that 3%.

 

  1. “Never put your money in something where you don’t have an information advantage.”  “Most people won’t put in the time to get a knowledge advantage.”  Charlie Munger agrees with Cuban and advises investors to “Look for more value in terms of discounted future cash-flow than you are paying for. Move only when you have an advantage.” In trying to buy something for less than it is worth, you should be working to create an information advantage over the seller. How do you do that?  Howard Marks points the way: “Mistakes are all that superior investing is about.  In short, in order for one side of a transaction to turn out to be a major success, the other side has to have been a big mistake. There’s an old saying in poker that there’s a “fish” (a sucker, or an unskilled player who’s likely to lose) in every game, and if you’ve played for an hour without having figured out who the fish is, then it’s you.  Likewise, in every investment transaction you’re part of, it’s likely that someone’s making a mistake.  The key to success is to not have it be you.”  If you do not have an information advantage or are not willing to do the work to get an information advantage, put your money in a low cost diversified portfolio of index funds.

 

  1. “I placed too much importance on comparing how much I had to others early on. Then I started realizing time was a far more valuable asset.” “The cheaper you can live, the greater your options.”  Jealously is a useless emotion. Nothing good comes from jealousy. Ever. It is a far better idea to focus any energy that would be wasted on jealousy on creating more time to do what you love. The best thing that money can give you and people you love is better choices. People who do not have any money have terrible choices. Over the years I have seen a lot of people with expensive luxury possessions  who do not have the cash required to always have the ability to make have good choices in their life. Liquidity matters. Howard Marks recently said: “When you go into risk assets and they go through a tough period, there will be heartburn and price declines. If you are going to need the money in the short term, you shouldn’t put it into potentially illiquid assets.” Having enough cash in the bank so you always have good choices is the ultimate luxury. No car, boat or house could ever be better than that feeling. CNBC’s Joe Kernan said to Marc Cuban in 2000: “Don’t you feel dumb that you cashed out your Yahoo stock at $200 & now it’s trading at over $230?”” Cuban answered: “Well, it’s hard to feel dumb when you’re flying around in your GV.” More importantly Cuban added: “I asked myself – what’s the worst that could happen? I walk away with $2B in the bank? How much money do I really need?”

 

Notes:

USC Interview  https://www.youtube.com/watch?v=fs9Gr8Gj6Cg

Inc Interview  http://www.inc.com/lindsay-blakely/mark-cuban-sterling-nba-entrepreneurship.html

Young Money Interview: http://finance.youngmoney.com/entrepreneur/entrepreneur-advice/041703_01/

Blog Maverick  http://www.businessinsider.com/mark-cubans-guide-to-getting-rich-2015-9

Twelve Rules   http://www.businessinsider.com/mark-cuban-rules-startups-tips-strategy-entrepreneur-2015-5

Michael Mauboussin on Babe Ruth:  http://turtletrader.com/pdfs/babe-ruth.pdf

Chris Dixon on Babe Ruth:   http://cdixon.org/2015/06/07/the-babe-ruth-effect-in-venture-capital/

Memory: http://www.northwestern.edu/newscenter/stories/2012/09/your-memory-is-like-the-telephone-game.html

A Dozen Things I’ve Learned from Jenny Lee about Investing and Business

“Jenny Lee joined GGV Capital in 2005 as a managing partner and was instrumental in setting up the GGV presence in China. Her previous operation and finance work experience with Singapore Technologies Aerospace, Morgan Stanley and JAFCO Asia enhanced her role as a preferred board mentor and investor to many entrepreneurs in China. She graduated from Cornell University with a Masters and B.Sc. in Electrical Engineering and an M.B.A. from Kellogg School of Management, Northwestern University.” 

1. “Start-ups aren’t an object. They’re successful because of the people behind them.” Great people, attractive markets, significant innovation are the three key elements in any successful business. What a venture capitalist wants to find in a founder is a certain sort of person. These founders are not identical, but do share certain attributes. One of the desired attributes in a business founder is a missionary attitude toward the business. Missionaries rather than mercenaries are the founders who create the startups that make the biggest impact. Other desired qualities in a founder include persistence, curiosity, energy, the ability to communicate and sell, focus, determination, intelligence and the ability to adapt to change. These attributes should be sought not just in founders but in the teams they assemble to build and run the business. Having a diverse team in every sense is important. Different people have different skills and sometimes someone’s strength is also their weakness.

 

2. “[Founders] must have the hunger to learn about new things and have the tenacity to persist in one’s judgment despite naysayers – and there will be a lot of them – and, finally, that firm belief that a single person or a single company can create products or business models that can change the world.” “You need to believe that you can clear everything in your path.”  Some people may think it is an odd combination, but founders who are confident and yet humble are mostly likely to succeed. The more you know and the more experience you get in life, the more humble you should be. Part of the reason Charlie Munger is so wise is that he believes: “Knowing what you don’t know is more useful than being brilliant. … real knowledge is knowing the extent of one’s ignorance.” Successful founders tend to have strong views, loosely held. If you do not have strong views, you have not done the research and probably don’t know both sides an issue. If those strong views are not loosely held, it is unlikely you will be able to adapt as new information and ideas arrive.

 

3.“We are looking for the 2% who are going to change the world.” Tape measure home runs drive financial returns in the venture capital industry. To get a tape measure home run you must have founders who are aiming to significantly change the world since otherwise the revenue and profit growth will not be sufficient. The best venture capitalists are constantly searching for outliers. This must be the case given how high the bar has been set by the venture capital business model. To explain how high the bar is set, this is my riff on a quote by Warren Buffett using new numbers and slightly altered language:

“Think about a company with a market cap of $1 billion. To justify paying this price, you would have to generate profit $100 million every year until perpetuity, assuming a 10% discount rate. And if the business doesn’t begin this payout for a year, the figure rises to $110 million annually, etc. Think about how many businesses today generate profit of $100 million a year.”

Consider how big a financial win must be to move the needle in venture capital. Fred Wilson described the math in this post: 

“First, the money needs to generate 2.5x net of fees and carry to the investors to deliver a decent return. Fees and carry bump that number to 3x gross returns. So $25bn needs to turn into $75bn per year in proceeds to the venture funds. Then you need to figure out how much of the companies the VCs normally own. The number bandied about by most VCs is 20%. That means that each VC investor owns, on average 20% of each portfolio company. We’ll use that number but to be honest I think it’s lower, like 15% which makes the math even tougher. Using the 20% number, that $75bn per year must come from exits producing $375bn in total value. But it is also true that many of these exits have multiple VC investors in them, sometimes three or four. So you really need to look at the percent ownership by VC funds in the average deal at the time of exit. That number is likely to be over 50% and maybe as high as 60%. If we use 50%, then to get $75bn per year in distributions, we need to get $150bn per year in exits.” 

 

4. “I’m a very gut feel type of investor.” There are no formulas which will always generate success in venture capital.  If there were simple success formulas that could be applied mechanically nearly everyone would be rich.  There are some general principles that can be applied by successful practitioners which can increase the probability of success. One such principle is: venture capital is the search for investment with significant convexity (big financial upside with a correspondingly small downside). When a venture investment is made what the venture capitalist can lose is limited to what they invest. But the financial return can potentially be hundreds or even thousands of times the initial investment. A tape measure home run will not happen often with a venture investment but when it does the venture capitalist may sing the hallelujah chorus even if they are not religious. Finding undiscovered convexity that is being offered at a substantial bargain means the venture capitalist must be continually looking for it in new places. Once an investment idea is appearing regularly in the newspapers and tech blogs it is often too late to find the greatest opportunities. Finding a new approach requires that the approach be new in some important way. There must be at least one key element of the business that is fundamentally different from what has been done before. That something which is different is always different that what was different the last time.

 

5. “It’s a tough market and more of a challenge to find the gems. But it’s a great time to start; the quality of entrepreneurs has increased. I love the winter.” Often the best time to start a business is during a downturn in an economy. The competition for the best employees is lower during a financial correction as is competition in markets generally. During an economic downturn there is also less noise that can distract a business which enables more focus on business fundamentals. In a tough market there is often less thinking about distracting things like pivoting and more focus on getting things done.

 

6. “If you’re a late-stage company, a growth-stage company, and you’re looking to be a public company, the market fluctuation does affect you. If you are further down the chain on the early-stage side, then I would say that the capital markets play less of an impact, but it does affect how those companies now think about the quality of that capital, the stability of the capital, and the investor behind the capital.” Being an early stage startup during a downturn can be a relatively good place to be. In contrast, needing loads of capital during a lousy funding environment is not a great place to be. It is inevitably shocking for people going thorough their first business cycle when the cash spigot goes dry (i.e., it becomes hard or just plain impossible to raise new cash). Having a plan in the event the business can raise no new cash is wise. People like Mitch Kapor and Josh Kopelman now are talking about a Watney rule: “We need to act we’re like Mark Watney in the Martian. We can’t assume we will get a shipment of new potatoes to save us.”

  

7. “[Founders should understand the] fit between the company, their sector, the VC firm and the partner in charge.” Every founder and startup has different skills, resources, talents and needs. Every venture capitalist is also unique, as are venture firms.  “Founder-VC fit” is enough of a success factor in building a business that extensive due diligence by founders to find the right investors is wise. Founders should talk to other founders about their experiences with any given venture capitalist before making a choice. Selecting a venture capitalist is like deciding to marry someone. Unfortunately, sometimes there is only one person that will have you. But that is not your ideal situation.

  

8. “For work, if the product is good, there is a paying tendency.” Enterprise customers are more likely to be willing to pay cash for services than consumers who have been conditioned to expect services “for free.” Ben Thompson describes the problem with enterprise sales in a recent issue of his newsletter: “Productivity apps usually have high learning curves.” Most people today are attacking this problem with freemium. During the free period in the freemium model the user gets religion in a very low cost way through self-education and then they are sold the equivalent of guidebooks for that religion and become paying consumers.  Freemium is, at its core, about lowering CAC (customer acquisition cost)! This is the “land and expand” business model use by businesses like Slack and Atlassian which does not require the same level of sales and marketing spending as a Beatles sale and marketing approach (“I want to hold your hand”).  If your competitor is using a land and expand approach they can often undercut your price if you do not adopt it too. The new wrinkle on enterprise investing is that many businesses that once upon a time would have sold tools to enterprise markets have become what is known as “full stack.” Chris Dixon writes: “Suppose you develop a new technology that is valuable to some industry. The old approach was to sell or license your technology to the existing companies in that industry. The new approach is to build an end-to-end product or service that bypasses existing companies.” Oracle sells tools, but Tesla and Uber sell a full stack offering in that they provide everything, including the service to the end user.  This full stack phenomenon and the rise of freemium have many important ramifications that I plan to write more about at some point.

 

9. “The monetization technique in China cannot just be advertising-supported. The China population is actually a paying population. They pay for games, things that they don’t even need. They pay for virtual items so they can look like a duke. They drive a virtual BMW to a concert that’s all online. They can pay. This is the young generation. For them, do I line up, get stuck in traffic, buy a 300 renminbi ticket, be stuck in auditorium? Or can I do that for 100 bucks and look like a king online? So the time has changed, and therefore, if you have users, any company should try to monetize through various ways. That’s how we push our CEOs when they say, ‘Well, this is how the West does it.’ We say, ‘Let’s see if the East can do it better.’” “[In China] most people do not consume ads online, especially on mobile. “The lack of a fully built-out offline retail and services in second- and third-tier cities in China means that many services and products are not available offline. Variety and convenience factors are lacking. Hence mobile commerce is a very natural transaction-based value for users.  Thanks to Alipay and Tencent’s further efforts to tie users’ phones to payment providers, the ease of payment has greatly enhanced e-commerce, and anytime anywhere transactions via the mobile devices.” China is not only a huge market but a key part of the global supply chain. As a market and supply base doe most companies it cannot be ignored. So for a business the right question is how you deal with China rather than whether you deal with China. I spent four years of my life working in Seoul Korea and even wrote a book about doing business in that country. What I took away from that experience of living in Korea and later Australia was how little I know about the country despite living there and that even if I spent a lifetime working there I would still have much more to learn. When dealing with a county and culture where you are not a native, it is wise to know as much as you can about what you do not know. To help deal with cross cultural and other differences it is best to have a relationship mentality rather than a deal mentality.  That is the principal thesis in my book The Global Negotiator, which is free to read on my blog:  https://25iq.files.wordpress.com/2016/05/the_global_negotiator.pdf

 

10. “One of the most common questions we hear today is, ‘How can I take my model to the other side?’ U.S. companies always come to us and say, ‘I am doing this in the U.S. Should I be doing it in China first?’ If you’re an entrepreneur, you’re no longer just thinking ‘my hometown.’ Some of them come from the point of: ‘If I don’t do this on a global basis first, someone is going to copy me.’ I’m sitting in China; somebody is going to copy me in the U.S. I’m sitting in the U.S.; somebody is going to copy me in China.”  Once upon a time people thought of innovation as happening in the west and then moving to China. Now the flow is moving in both directions. This is a very good thing since the world benefits from more innovation.

 

11. “If you can do without China, and you have this fear of setting up there, then don’t go. But if you are in the makers community, 90 per cent of your supply chain is in China. So in not going, you will fail.” “Maybe you can find that 10 per cent in Vietnam, but the price is not going to be the same (and you will encounter the same problems anyway.) If your business requires you to be in China, then my advice as an entrepreneur is figure how to get smart about it. It is as simple as that. There’s no perfect answer.” China is not only a huge market but a key part of the global supply chain. Not only is China a great opportunity for any business but in some industries it simply can’t be ignored. So for a business like this they face a question how they deal with China rather than whether they deal with China.

 

12. “My friends told me I was crazy to leave the iron rice bowl that ST Engineering provided. But I had to take the risk. To get what you want, you must get it yourself.” After graduating from Cornell, Lee started her career in Singapore as an aerospace engineer. She could have stayed in that job and been very secure financially. But instead she did what she needed to do to achieve her goals. Startups are not a great place for people who value security highly. The reality is that most startups fail. The struggle to build a business from scratch is inevitably hard. Elon Musk has said: “A friend of mine said running a start-up is like chewing glass and staring into the abyss. After a while, you stop staring, but the glass chewing never ends.” If you are not a missionary about the mission of a startup the odds that you will endure the many rejections and hardships goes way down. Venture capitalists know from experience that people who are working on the idea or dream of someone else are not as likely to stay the course. Many startups have been inches from failure before the eventually found success. Getting through all the glass chewing is a job best suited for missionaries.

 

Notes: 

Bloomberg:  http://www.bloomberg.com/news/articles/2014-06-13/jenny-lee-of-ggv-capital-has-an-eye-for-chinas-rising-tech-giants

Forbes: http://www.forbes.com/sites/ryanmac/2015/03/25/jenny-lee-midas-list-top-ranked-woman-interview-china/#4d0983ef227e

Inc. http://www.inc.com/lisa-calhoun/34-surprising-facts-about-top-tech-investor-jenny-lee.html

Interview: http://www.techrepublic.com/article/jenny-lee-venture-capital-investor-golfer-fighter-jet-engineer/

http://www.cnbc.com/2015/08/25/top-china-investor-jenny-lee-bets-on-robots-drones.html

Podcast: http://typewriterintl.com/2015/08/25/interviewing-jenny-lee-from-ggv-capital/

Strictly VC http://www.strictlyvc.com/2015/08/12/jenny-lee-of-ggv-capital-on-what-to-know-now-about-china/

Stanford panel: https://www.youtube.com/watch?v=apqd5rWSbfI

Straits Times: http://www.straitstimes.com/business/invest/jenny-lee-a-guiding-star-in-the-world-of-tech-start-ups  http://www.straitstimes.com/business/invest/after-riding-internet-wave-singapores-top-china-investor-jenny-lee-bets-on-hardware

CCTV http://www.cctv-america.com/2015/12/18/venture-capitalist-jenny-lee-eyes-chinas-investment-future

Fred Wilson:   http://avc.com/2009/04/the-venture-capital-math-problem/

A Dozen Things I’ve Learned from Eugene Kleiner about Investing and Business

Eugene Kleiner was an Austrian-born American engineer and venture capitalist. He worked for William Shockley at Shockley Semiconductor Laboratory starting in 1956. The next year he and seven colleagues (the so-called the “traitorous eight“) famously left Shockley to found Fairchild Semiconductor. They left because did not like Shockley’s management practices or his plans to use germanium to make semiconductors. “Using just $3,500 of their own money to get started, these eight entrepreneurs eventually developed a way to manufacture multiple transistors on a single silicon wafer.” Kleiner was one of the original founders of Kleiner Perkins, which was an early investor in more than 300 information technology and biotech firms, including Amazon, AOL, Brio, Electronic Arts, Flextronics, Genentech, Google, Intuit, Lotus, LSI Logic, Macromedia, Netscape, Quantum, Segway, Sun and Tandem. Kleiner’s obituary in the Economist includes this sentence: “To the end of his life, he called himself an engineer.” Despite his technical background Kleiner made major contributions to the world as a financier. That obituary notes it was Kleiner’s letter “to his father’s stockbroker in New York that was passed to Arthur Rock that set off a chain of events that resulted in Rock moving to California and persuading  Sherman Fairchild, the inventor of the aerial camera, to make Mr. Kleiner’s little group a subsidiary of his company.”

 

  1. “Invest in people, not just products.” The KPCB web site elaborates on Kleiner’s first point: “Eugene always respected founding entrepreneurs. He wanted to build companies with them not just with their ideas.” The three legs of the stool that drive venture capital returns are: (1) great people, (2) attractive markets and (3) significant innovation.  If you neglect even one of the three you have a big problem. But there are disagreements among venture capitalists about emphasis and phasing. For example, people like Don Valentine argue that you can always replace the people, so it is better to place more emphasis on attractive market. Venture capitalists like Kleiner believe that replacing people is not only hard and unpleasant, but significantly lowers the convexity of the investment. Great people and teams are able to adapt in ways that solve problems. Without great people already in place, preferably missionaries, the probability of survival is significantly reduced in Kleiner’s view. Elad Gil had an interesting post this week on the importance of great founders which included these two paragraphs:


“There are a handful of venture firms that are always thesis-driven, for example Union Square investing in network driven businesses. However, most venture firms are admittedly reactive – they do not have a specific theme they are driving themselves, but rather respond to where the best entrepreneurs are creating the most high growth, high margin, companies fastest.

When lots of VC firms shift into a thesis driven mode, it is usually a sign that organic entrepreneurial activity is no longer sufficient to drive that firms investments. As a result, lots of capital gets invested in areas that do not merit the investment, there is a flurry of activity that looks important (Cleantech), but ultimately this activity does not yield great returns. Typically these areas are ones where the investors lack real expertise.”

 

  1. “It’s easier to get a piece of an existing market than to create a new one.”  “Two companies fighting over a niche market are like two bald men fighting over a comb.” Kleiner is agreeing with Valentine that attractive markets make the venture capital business model work since there is a need for tape measure financial home runs. The difference is that Kleiner, like Pitch Johnson and many other venture capitalists, consider people to be relatively more important. Kleiner is also saying that it is hard to create a new attractive market where none existed before. He is not saying that creating a new market is not valuable (that payoff can be enormous actually), but instead that it is hard to do. In contrast, fighting with other businesses over a niche market is not likely to be a pleasant or profitable activity.

 

  1. “Risk up front, out early.” A famous venture capitalist said to me about this comment that Kleiner: “Always had a strong bias of eliminating the biggest risks quickly, which was much more relevant in the days of backing companies with high technical risk and low market risk.” Another famous VC who knew Kleiner well wrote to me that what he meant by this sentence was: “Reduce the biggest risks first for the fewest dollars. This may mean out of order execution to minimize loss in case of failure.” Steve Blank points out that there are different types of risk that must be retired for a business to be a success: “Markets with Invention Risk are those where it’s questionable whether the technology can ever be made to work – but if it does customers will beat a path to the company’s door. Markets with Customer/Market Risk are those where the unknown is whether customers will adopt the product.”

 

  1. “The problem with most companies is they don’t know what business they’re in.” Venture capitalists who talk about this problem usually see the flip side which is that it can create opportunity for a challenger. This idea being important in venture capital can be traced at least all the way back to Georges Doriot, who said that US Steel did not know what business it was in.  Other venture capitalists believe businesses like Kodak and DEC late in their life had the same problem as US Steel. In the case of Kodak the company invented the technology that would eventually prove to be its undoing. This point made by Kleiner is applicable to service businesses too. For example, Mark Cuban said once: “You always have to know what business you are in. Everybody thought we were in the basketball business. It’s an NBA-team; we are not in the basketball business. We are in the business of creating experiences and memories.”

 

  1. “Make sure the dog wants to eat the dog food. No matter how ground-breaking a new technology, how large a potential market, make certain customers actually want it.” “There are two types of early adopters. Those who buy and those who want the product given to them.” This quote is a nod by Kleiner to the importance of determining whether there is “product market fit” before scaling a business. Premature scaling is a common cause of startup death. The other point Kleiner is making is that someone must pay for something for a business model to work.  Freemium only make sense as a business model if there is a complementary good that customers are willing to pay for. Rihanna may have a hard time selling music these days since digital music is non rival, but if she uses the fame generated by her music to sell tickets to concerts and t-shirts with her name on them she can still do very well. Her Diamonds World Tour in 2013 grossed US$137,982,530 from 87 shows.

 

  1. “The more difficult the decision, the less it matters what you choose.” Sometimes you are better off making a decision and living with it than agonizing over the decision for a long period and as a result experiencing a significant delay. Kleiner is saying the harder the decision is to make, the more this is true. One famous decisions concerned what material to use in making semiconductors.  William Shockley wanted to use germanium.  Kleiner ans his colleagues wanted to use silicon instead.  People sometimes joke that without Kleiner the term used today would be “Germanium Valley” not Silicon  Valley.

 

  1. “Build one business at a time. Most business plans are overly ambitious. Concentrate on being successful in one endeavor first.”  “What tips me off that a business will be successful is that they have a narrow focus of what they want to do, and they plan a sufficient amount of effort and money to do it. Focus is essential.” The number of people who can run multiple businesses at one time is truly tiny. What Steve Jobs did at Pixar and Apple is not normal.  In addition, the propensity of a founder to pivot is negatively correlated with success. Focus matters. When Bill Gates and Warren Buffett met for the first time at dinner that night “Bill Gates Sr posed the question to the table: What factor did people feel was the most important in getting to where they’d gotten in life? And [Warren Buffett] said, ‘Focus.’ And Bill said the same thing.”

 

  1. “You have to create deals to be really successful.” Success in venture capital is in no small part about hustle. The best venture investors beat the bush for prospects and ideas and have the best referral networks. They are curious and open to new ideas. Reading and talking to people they believe are smart and knowledgeable is a constant activity. Finding the university researchers does not happen by accident. Networks of friends and people you have helped can feed back valuable information in very positive ways.

 

  1. “The time to take the tarts is when they’re being passed.  When the money is available, take it.” “When the hors d’oeuvres are passing, take two.” Venture capital is a cyclical business. Sometimes it is easy to raise money, sometimes it I merely hard and sometimes it is impossible. It is better to have more money than you need and not need it, than need it and not have it. The absence of cash is fatal. So it is wise to have a margin of safety when it comes to cash. Yes, dilution is an issue but if a venture backed business is a hit, there will be more than enough financial return for everyone.

 

  1. “Even turkeys can fly in a high wind. In times of strong economies, even bad companies can look good.” This is a variation of Warren Buffett’s point that: “you only find out who is swimming naked when the tide goes out.” The problem, of course, is that you do not always know when a tailwind is about to rapidly slow or even cease. In fact, sometimes you don’t know if what you are experiencing is a tailwind at all. The best founders are prepared for any outcome.

 

  1.  “It’s difficult to see the picture when you’re inside the frame.” Having perspective on something when you are an insider is hard. Self interest and other biases are powerful enough that dysfunction can result from insider status. The venture capitalist having a network of people who the founders can count on for perspective and feedback is important. Charlie Munger has a great story about this set of issues:

“You also have to allow for the self-serving bias of everybody else, because most people are not going to remove it all that successfully, the human condition being what it is. If you don’t allow for self-serving bias in your conduct, again you’re a fool. I watched the brilliant Harvard Law School trained general counsel of Salomon lose his career, and what he did was when the CEO became aware that some underling had done something wrong, the general counsel said, “Gee, we don’t have any legal duty to report this but I think it’s what we should do it’s our moral duty.” Of course, the general counsel was totally correct but of course it didn’t work; it was a very unpleasant thing for the CEO to do and he put it off and put it off and of course everything eroded into a major scandal and down went the CEO and the general counsel with him. The correct answer in situations like that was given by Ben Franklin, he said, “If you want to persuade, appeal to interest not to reason.” The self-serving bias is so extreme. If the general counsel had said, “Look this is going to erupt, it’s something that will destroy you, take away your money, take away your status…it’s a perfect disaster,” it would have worked!”

 

  1. “Venture capitalists will stop at nothing to copy success.” The venture capital industry has no shortage of camp followers and poseurs like other industries. It is a fact of life that in capitalism that any success will be quickly copied and that moats are needed to sustain any profit. The best venture capitalists are already leaving a market, when the poseurs show up. What is the moat in venture capital itself? My view is that it is cumulative advantage that causes a few firms to have persistently  higher returns. The best essay on this topic  was written by Duncan Watts and is entitled: Is Justin Timberlake a Product of Cumulative Advantage?   http://www.nytimes.com/2007/04/15/magazine/15wwlnidealab.t.html?_r=0

 

Notes:

Giants: http://web1.poly.edu/alumni/_docs/Giants-Kleiner.pdf

Economist Obituary:   http://www.economist.com/node/2265786

NYT Obituary: http://www.nytimes.com/2003/11/26/business/eugene-kleiner-early-promoter-of-silicon-valley-is-dead-at-80.html

KPCB: http://www.kpcb.com/design/on-investing-by-eugene-kleiner

Elad Gil:  http://blog.eladgil.com/2016/07/end-of-cycle.html?utm_campaign=digest&utm_medium=email&utm_source=app&m=1

A Dozen Entries from the Venture Capital Devil’s Dictionary

The Devil’s Dictionary is a satirical dictionary written by the American journalist and author Ambrose Bierce. This humorous book was originally published in 1906 as The Cynic’s Word Book. One of my favorite writers, Jason Zweig of the Wall Street Journal, is the author of the newly published and wonderful book: The Devil’s Financial Dictionary.

What follows are a dozen terms used in the venture capital industry, defined in Devil’s Dictionary fashion.

 

  1. “Burn Rate” the speed at which available cash is being consumed. Expenses such as inter-floor office slides, nerf guns, office space with water views, corporate retreats to other continents, dog chefs, and free Kind bars are sometimes put in a numerator of a fraction and expenses like salaries and electricity in the denominator, with the resulting number expressed as what is known as “an idiocy ratio.”

BurnRate

  1. “Chicken and egg problem” – describes a “which one came first?” problem, such as jump starting a multi-sided market. Explains why the first sale of fax machines was probably not just one machine. Which reminds me of a story: A chicken and an egg are lying in bed. The chicken is smoking a cigarette with a satisfied smile on its face and the egg is frowning and looking a bit pissed off. The egg mutters, to no-one in particular, “Well, I guess we answered THAT question!”

 

  1. “Dog and pony show”- a presentation that is long on showmanship and light on substance originally used in the United States in the late-19th and early-20th centuries to refer to small traveling circuses that toured through small towns and rural areas and startup pitches at Angel investor clubs composed of proctologists, dentists and beauticians.

dogandpny

  1. “Ducks are quacking, so feed them” – describes what some startups do when it is easy to raise cash (e.g., feed amateur Angel investors shares in return for cash). If a business does not hear ducks quacking and has no cash reserves raised during a period of time that was “quack rich,” the business may soon auger into the ground at high speed. Cash is financial Valium.

ducks

  1. “Exit strategy” – a plan to generate cash from the sale of a business or part of a business. The more a founder talks about his or her “exit strategy” the less attractive the investment. See also: Mercenary. Gary Larson has a Far Side cartoon strip in which one chicken is shown talking to another while they sitting on beach chairs holding umbrella drinks saying: “Man, they made me a free-range chicken and I never looked back.” A founder who is driven to be sitting in a beach chair holding an umbrella drink is not likely to be successful.

 

  1. Growth hacking”- a glorified term for sales and marketing using analytics. Using the word “hacking” as part of the term makes a non-technical person sound more like an engineer who seems to have a cooler job since they use words like grok, DevOps and Rails.

 

  1. “Hockey stick”- what a line on a chart representing something like revenue growth looks like when that distribution is calculated as a goal seek in a spreadsheet (up and to the right, to infinity and beyond).

hockey stick

  1. “Pivot”- a new direction or path for the business if the original idea turns out to be crap. Scott Adams of Dilbert fame writes: “For example, a company starts out selling PEZ dispensers online and later pivots to become eBay. You didn’t hear about all of the companies that failed so the pivot stories probably sounded more prevalent than they were. It’s similar to how a story of one shark attack makes you think there’s a Great White under every surfboard. The human brain assumes that whatever it hears most frequently must be the best reflection of reality.”

 

  1. Ramen profitable” – Just enough profit to afford to eat ramen with the “profits” of the business. Profit is unfortunately an opinion whereas absolute dollar free cash flow is a fact. While there may sometimes technically be “profit” based on someone’s definition/opinion there may not actually be cash to buy ramen. The instant noodles are usually purchased by the case or even a pallet from a “cash and carry” store or Costco.

ramen

 

  1. “Runway”- the number of months the available cash will last if the current burn rate continues. Not to be confused with “run away” which is what you should do when founders use words like “paradigm” or “e-business” in their pitch deck.

tweet rop

 

  1. “Telling someone their baby is ugly”- giving someone the news that their idea or creation is doomed to fail.  Best done by someone else. See: delegate.  As H.L. Menken once said:  “When A annoys or injures B on the pretense of saving or improving X, A is a scoundrel.”

 

  1. “Zero-billion dollar market”- A small unattractive market for a venture capitalist, often fought over by a group of businesses that reminds you of several bald men fighting over a hair brush. H/T Eugene Kleiner.

 

Notes:  

Jason Zweig- The Devil’s Financial Dictionary.  https://www.amazon.com/Devils-Financial-Dictionary-Jason-Zweig/dp/1610396995

Scott Adams: http://blog.dilbert.com/post/103051127931/the-pivot

VC Jargon: http://www.sherpapartners.com/Sherpa_Jargon.htm

Glossary: https://www.cbinsights.com/research-venture-capital-terms?ads_cmpid=270202443&ads_adid=24533358603&ads_matchtype=p&ads_network=g&ads_creative=86955087243&utm_term=vc%20terms&ads_targetid=kwd-142600249443&utm_campaign=&utm_source=adwords&utm_medium=ppc&ttv=2&gclid=CNzDjYubs80CFVKDfgodAhYGiA